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Lecture 6: Off-Balance-Sheet
and Sovereign Risks
 2

Off-balance sheet
risks
Overview

 This chapter discusses the risks associated with off-

balance-sheet activities. OBS activities are often designed
to reduce risks through hedging with derivative securities
and other means. However, as several high profile events
have demonstrated, OBS risk can be substantial.
Regulatory policy has been altered as a result of accounting
abuses and other unethical practices.
Off Balance Sheet Risks

 Contingent assets
 Contingent liabilities
 Derivative Securities
 Held Off the Balance Sheet:
 Forward contracts
 Futures contracts
 Option contracts
 Swap contracts
OBS Activities

Infamous cases:
 Barings.
 NatWest Bank
 Midland Bank
 Chase Manhattan
 Union Bank of Switzerland
 Metallgesellschaft.
 Banker’s Trust.
 CSFB/Orange County, CA.
 Sumitomo Corp.
 Long-Term Capital
 AllFirst Bank/Allied Irish Bank
 J.P. Morgan Chase & Citigroup
 Amaranth Advisors
 11
-6
Off-Balance-Sheet Activities and
FI Solvency
 Off balance sheet assets & liabilities:
 Appear ‘below the bottom line’ in financial statements.
 Contingent assets or liabilities,
 Potential for these assets and liabilities to produce
negative or positive returns to the FI,
 Probability of moving onto the balance sheet < 1.

 Valuation of OBS items:

 Delta of an option, i.e. the change in the value of an
option for a small unit change in the price of the
underlying security.
 Notional value (face value, = F) of an OBS item.
 11
-7
Off-Balance-Sheet Activities and
FI Solvency
Valuation of OBS items (continued):
dO
d  delta of an option 
dS
Delta equivalent value = d × F
Delta varies with level of price of underlying
security, that is:
0 < d < 1.
Valuation

True picture of net worth

 Should include market value of on- and off-balance-
sheet activities.
E = (A – L) + (CA – CL),
where: CA = contingent assets,
CL = contingent liabilities.

i.e., Equity = Assets – Liabilities + Contingent – Contingent

Assets Liabilities
Exposure to OBS risk just as important as other
risk exposures
 9

Net Worth With And Without

OBS
Changes in OBS (Billions)

1992 2006

Futures & Forwards $4,780 $13,788

Swaps 2,417 74,438
Options 1,568 24,447
Credit Derivatives — 6,569
Total 8,765 119,243
Incentives to Increase OBS
Activities
Losses on Less Developed Countries (LDC)
loans and reduced margins produced profit
incentive.
 Increases in fee income.
Avoidance of regulatory costs or taxes.
 Reserve requirements.
 Deposit insurance premiums.
 Capital adequacy requirements.
The 5 OBS Activities (Schedule
L)
1. Commitments
 Loans commitments
2. Letters of credit: LCs & SLCs
3. Derivatives: Futures, forwards, swaps and options
4. When issued securities (securities
underwritting)
 Commitments to buy and sell securities prior to issue.
5. Loans sold
 OBS only if sold without recourse
Commitments

Examples:
Sale and repurchase agreements,
Assets sold with recourse,
Forward asset purchases,
Partly paid shares and securities,
Placements of forward deposits,
Underwriting facilities,
Standby lines of credit,
Commitments

 Commitments may incur back-end fee.

 Interest rate risk:

 On fixed-rate loan commitments the bank is exposed to
interest rate risk.
 On floating-rate commitments, there is still exposure to
basis risk.

 Draw-down risk:
 Uncertainty of timing of draw-downs exposes bank to risk.
Commitments
 Credit risk:
 Credit rating of the borrower may deteriorate over the
life of the commitment.
 Addressed through ‘adverse material change in
conditions’ clause.

 Aggregate funding risk:

 During a credit crunch, bank may find it difficult to
meet all of the commitments (compare to externality
effect).
 Bank may need to adjust its risk profile on the balance
sheet in order to guard against future draw-downs on
loan commitments.
Direct Credit Substitutes and
Trade- and Performance-Related
Items
Example of trade-related item: letters of credit
(LCs).
Example of direct credit substitute: standby
letters of credit (SLCs).
Both are guarantees sold by an FI and thus
contingent liabilities.
LCs: bank underwrites the trade or commercial
performance of the LC buyer.
SLCs: cover contingencies that are potentially
more severe and less predictable.
Simple Letter of Credit
Transaction
Derivative Contracts

Used by FIs for hedging purposes

Or FIs acting as dealers
 Big Three Dealers: J.P. Morgan Chase, Bank of America,
Citigroup.
 87% of derivatives held by user banks
Futures, forwards, swaps and options.
 Forward contracts involve substantial counterparty risk
 Other derivatives create far less default risk.
When Issued Trading

Commitments to buy and sell securities prior to

issue. Example: commitments taken in week
prior to issue of new T-bills.
 The risk is that the bank may over commit as with
Salomon Brothers in market for new 2-year bonds in
1990. Caused the Treasury to revise the regulations
governing the auction of bills and bonds.
Loans Sold

Exposure to risk from loans sold unless no

recourse
 Ambiguity of no recourse qualification
 Reputation effects may amplify the FI’s contingent
liabilities
Loans Sold With and Without
Recourse
Schedule L and Nonschedule L
OBS Risks
FIs other than banks may engage in many of the
OBS activities discussed so far.
Banks have to report the five OBS activities
(discussed in preceding slides) each quarter as
part of Schedule L of the Call report.
Non-Schedule L Activities

Settlement Risk—FedWire is domestic. CHIPS

is international and settlement takes place only at
the end of the day. Leaves the bank with intraday
exposure to settlement risk. During the day,
banks receive provisional messages only.
Affiliate risk—occurs when dealing with One-
Bank Holding Companies (OBHCs) and Multi-
Bank Holding Companies (MBHCs) .
 Creditors of failed affiliate may lay claim to surviving
bank’s resources.
 Effects of source of strength doctrine.
The Role of OBS Activities

OBS activities are not always risk increasing

activities.
In many cases they are hedging activities
designed to mitigate exposure to interest rate risk,
foreign exchange risk etc.
OBS activities are frequently a source of fee
income, especially for the largest most credit-
worthy banks.
Websites

American Banker www.americanbanker.com

Federal Reserve Bank www.federalreserve.gov
Bank of America www.bankofamerica.com
Citigroup www.citigroup.com
CHIPS www.chips.org
FDIC www.fdic.gov
J.P. Morgan/Chase www.jpmorganchase.com
NY Board of Trade www.nybot.com
OCC www.occ.treas.gov
U.S. Treasury www.ustreas.gov
Vietnamese Accounting Standards
for OBS Activities

 No clear classification and details for OBS items. No standards exist for
recognition and measurement of complex Financial Instruments or
problems
 Inconsistent in treatments among local banks
 FI should refer to IFRS or US GAAP for classification, accounting
treatment and disclosure
 OBS items are recorded in “the notes to the financial statements of an
enterprise” (VAS 21):
 should explain OBS items’ measurement basis (bases) and accounting policies
applied in the notes to the FS
Vietnamese Accounting Standards
for OBS Activities
 For specific contingencies and commitments (including off-balance sheet
items), VAS 22 requires bank’s disclosure:
(a) the nature and amount of commitments to extend credit that are irrevocable because they cannot be
withdrawn at the discretion of the bank without the risk of incurring significant penalty or expense; and
(b) the nature and amount of contingent liabilities and commitments arising from off balance sheet items
including those relating to:
(i) credit substitutes including general guarantees of indebtedness, bank acceptance guarantees and
standby letters of credit serving as financial guarantees for loans and securities;
(ii) certain transaction-related contingent liabilities including performance bonds, bid bonds, other
warranties and standby letters of credit related to particular (special) transactions;
(iii) short-term contingent liabilities arising from the movement of goods, such as documentary credits
where the underlying shipment is used as security;
(vi) other commitments, note issuance facilities.
 28

Sovereign risk
Overview

 This chapter explores the risks FIs face when dealing with
foreign governments.
 We compare and contrast credit and sovereign risk.

 We examine the concept of debt repudiation and debt

rescheduling.
 We learn about techniques for evaluating a country’s risk
profile and ratios that can estimate the financial health of
an economy.
 We examine secondary markets for bonds issued by
developing countries and the techniques available to
address defaults.
Introduction

In 1970s:
 Expansion of loans to Eastern bloc, Latin America and
other LDCs.
Beginning of 1980s:
 Debt moratoria announced by Brazil and Mexico.
 Increased loan loss reserves
 Citicorp set aside additional $3 billion in reserves for
example
Introduction (continued)

Late 1980s and early 1990s:

 Expanding investments in emerging markets.
 Peso devaluation and subsequent restructuring
 U.S. loan guarantees under Clinton Administration
More recently:
 Asian and Russian crises.
 Turkey and Argentina
 Argentina’s focus on fiscal surplus
 Economic growth in the 2000s and reduction in
external debt.
 MYRAs
 Brady Bonds
Were Lessons Learned?

U.S. FIs limited exposure to in Asia during mid

and late 1990s
 Not all: Chase Manhattan Corp. emerging market losses
$150 million to $200 million range
 Poor earnings by J.P. Morgan.
Losses in Russia with payoffs of 5 cents on the
dollar
Credit Risk versus Sovereign Risk
Governments can impose restrictions on debt
repayments to outside creditors.
 Loan may be forced into default even though borrower
had a strong credit rating at origination of loan.
 Legal remedies are very limited.
Need to assess credit quality and sovereign risk
Sovereign Risk

Debt repudiation
 Since WW II, only China, Cuba and North Korea have
repudiated debt.
 Recent steps to forgive debts of most severe cases
conditional on reforms targeted to improve poverty
problems
Rescheduling
 Most common form of sovereign risk.
 South Korea, 1998
 Argentina, 2001
Debt Rescheduling

More likely with international loan financing

rather than bond financing
Loan syndicates often comprised of same group
of FIs versus large numbers of bondholders
facilitates rescheduling
Cross-default provisions
Specialness of banks argues for rescheduling but,
creates incentives to default again if bailouts are
automatic
Country Risk Evaluation

Outside evaluation models:

 The Euromoney Index, e.g., LIBOR
 The Economist Intelligence Unit ratings
 Highest risk in countries such as Iraq, Zimbabwe and
Myanmar.
 Institutional Investor Index
 2006 placed Switzerland at least chance of default and
Liberia as highest.
 U.S. not the lowest risk.
 Rating Agencies: Moody’s, S&P and Fitch
Country Risk Evaluation

Internal Evaluation Models

 Statistical models:
 Country risk-scoring models based on primarily
economic ratios.
Statistical Models

Commonly used economic ratios:

 Debt service ratio: (Interest + amortization on
debt)/Exports
 Import ratio: Total imports / Total FX reserves
 Investment ratio: Real investment / GNP
 Variance of export revenue
 Domestic money supply growth
Problems with Statistical Country
Risk Analysis (CRA) Models
Measurements of key variables.
Population groups
 Finer distinction than reschedulers and nonreschedulers
may be required.
Political risk factors may not be captured
 Strikes, corruption, elections, revolution.
 Corruption Perceptions Index
Problems with Statistical CRA
Models (continued)
Portfolio aspects
 Many large FIs with Low Development Countries (LDC)
exposures diversify across countries
 Diversification of risks not necessarily captured in CRA
models
Incentive aspects of rescheduling:
 Borrowers and Lenders:
 Benefits
 Costs
 Stability
 Model likely to require frequent updating.
Using Market Data to Measure
Risk
Secondary market for LDC debt:
 Sellers and buyers
Market segments
 Brady Bonds
 Sovereign Bonds
 Performing LDC loans
 Nonperforming LDC loans
Key Variables Affecting LDC
Loan Prices
Most significant variables:
 Debt service ratios
 Import ratio
 Accumulated debt arrears
 Amount of loan loss provisions
Websites

BIS www.bis.org
Heritage Foundation www.heritage.org
Institutional Investor
www.institutionalinvestor.com
IMF www.imf.org
The Economist www.economist.com
Transparency International www.transparency.org
World Bank www.worldbank.org
Mechanisms for Dealing with
Sovereign Risk Exposure
Debt-equity swaps
 Example:
 Citibank sells $100 million Chilean loan to Merrill
Lynch for $91 million.
 Merrill Lynch (market maker) sells to IBM at $93
million.
 Chilean government allows IBM to convert the $100
million face value loan into pesos at a discounted rate
to finance investments in Chile.
Multi Years Restructuring
Agreements (MYRAs)
Aspects of MYRAs:
 Fee charged by bank for restructuring
 Interest rate charged
 Grace period
 Maturity of loan
 Option features
Concessionality
Other Mechanisms

Loan Sales
Bond for Loan Swaps (Brady bonds)
 Transform LDC loan into marketable liquid instrument.
 Usually senior to remaining loans of that country.