Commercial Bank s Off-Balance Sheet Activities and Their

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Commercial Bank s Off-Balance Sheet Activities and Their

Transcript Of Commercial Bank s Off-Balance Sheet Activities and Their

Commercial Bank’s Off-Balance Sheet Activities and Their Relationship With Market-Based Risk Measures

Mukesh X. Chaudhry

Doctoral Candidate

Cleveland State University

Euclid Ave at East 24th Street

Cleveland, OH 44115

office phone: (216) 687-4716

residence:

(216) 253-0639

The commercial banks in the present deregulated environment are

confronted with a number of risk related issues.

Management of

interest rate risk which was largely ignored until the volatile

interest rate period of the 1980s became an important concern, as

a result of which a number of new financial

products have been

developed. instruments,

These products such as interest

are mostly off-balance

sheet

rate swaps, futures and forward

contracts, products, interest

options, in addition rate risk.

and securitization.

These financial

to providing fee income, do manage to hedge

However, use of these instruments have led

to a plethora

of different

types of risks for banking

institutions.

In this study a two stage model is developed.

In

the first stage, commercial bank stock returns obtained through

CRSP files is regressed against a two index model which comprises CRSP equally weighted index and an interest rate proxy. In the

second stage of analysis, various on- and off-balance

sheet risk

measures are regressed against the market-based risk measures

obtained

through

two index

model.

Containment

of

heteroskedasticity

is achieved through White's adjustment to OLS

model. It is evident that size based classification

is important

in the context of management of interest

rate risk by the

commercial banks. Large banks are in a stronger position of

managing their interest rate risk, whereas small banks are unable

to achieve unsystematic

interest

rate risk reduction.

risk provides important risk related

Furthermore, information

which is significant

from the point of view of regulators,

managers, uninsured depositors, and undiversified

stockholders.

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Les activitk hors bilan des banques commerciales et leurs relations avec les mesures des risques bas6es sur le march6
Mukesh K. Chaudry Cleveland State University Euclid Ave at East 24th Street
Cleveland. OH 441 15 U.S.A.
Telephone: (216) 687-4716 Telephone: (216) 253-0639
RBsume
Dans le contexte actuel dereglemente, les banques commerciales font face B un certain nombre de questions ayant trait au risque. La gestion du risque du taux d’interbt a 6th largement ignoree jusque dans les an&es 1980, marquees par une grande volatilite des taux d’interbt, ce qui a donne lieu a l’elaboration d’un certain nombre de nouveaux produits financiers. Ces produits sont pour la plupart des instruments hors bilan tels que les swaps de taux d’interbt, les contrats a terme et ?I terme ferme, les options, et la securitisation. Outre les revenus des commissions provenant de ces produits financiers, ceux-ci permettent de se premunir contre le risque de taux d’interbt. Toutefois, leur utilisation a provoque une plethore de differents types de risques pour les institutions bancaires. La presente etude Blabore un modele B deux phases. Dans la premiere phase, les rendements des actions des banques commerciales obtenus par les fichiers CRSP sont soumis B une operation de regression selon un modele B indice double de ponderation Bgale comprenant I’indice CRSP et un indice de taux d’interbt. Dans la seconde phase de I’analyse, diverses mesures du risque sur bilan et hors bilan font I’objet d’une analyse regressive par rapport aux mesures du risque basees sur le marche obtenues par le modele B double indice. Le controle de I’heteroskedasticite est obtenu par I’ajustement de White au modele OLS. II est evident que la classification d’apres les dimensions est importante dans le contexte de la gestion du risque du taux d’interbt par les banques commerciales. Les grandes banques sont mieux a mdme de gerer leurs risques de taux d’interbt, tandis que les petites banques ne parviennent pas a reduire ce risque. De plus, la nature non systematique du risque fournit des informations importantes ayant trait au risque, qui sont significatives du point de vue des regulateurs, des gestionnaires, des deposants non assures, et des actionnaires non diversifies.
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Commercial Bank’s Off-Balance Sheet Activities and Their Relationship With Market-Based Risk measures

1. Introduction

The dramatic rise in bank failures over the past several years

along with the perception that banks are resorting to increased

risk taking has led to a number of recent regulatory

reforms.

Several important risk related issues such as, interest rate risk

were largely unrecognized until the 1980s. As a result a number of

new financial

instruments

have been developed to offset the

increased riskiness of banking institutions.

These instruments

tend to mitigate interest rate risk.

However, use of these

financial products have led to completely different types of risks

for banking institutions.

There are a number of underlying factors that have caused

changes to occur in the riskiness of banking institutions.

Beebe

(1985)

indicates

that since 1979 there has been increased

volatility

in the financial

markets and significant

regulatory

changes have been instituted.

Similarly,

Santomero (1989)

identifies

four major forces that have impacted the banking sector,

namely, technological

innovations

in telecommunications

and the

computer industry, globalization

of the market place, advances in

financial

theory, and important deregulatory

changes.

These

developments led to two major banking reforms, namely, the

Depository Institutions

Deregulation

and Monetary Control Act

(DIDMCA) of 1980 and the Garn St. Germain Act of 1982. According

to Allen and Wilhelm (1988) and Cornett and Tehranian (1990), these

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4TH AFIR INTERNATIONAL COLLOQUIUM

regulatory changes were mandated by the fact that there was growing

awareness that financial institutions

were inadequately equipped to

meet the challenges arising from technological

advances, shifting

consumer demand for financial

services, and volatile

interest

rates'.

Another major issue which is likely to significantly

impact

the riskiness of banking institutions

relates to shifts in the

monetary policy regimes.

The Fed shifted from a federal funds

interest rate target to a non-borrowed reserve procedure in October

1979 and then just a few years later, in 1982, a decision was made

to deemphasize monetary targeting.

These, along with other

changes, lead to increased volatility

of interest rates (Saunders,

Strock and Travlos, 1990). Thus, overall banks now face broader

categories of risks, leading to greater variability

of returns.

These developments have made the issue relating to bank risk a

matter of great concern.

Hence, this study develops an analysis of the different

components of risk pertaining to banking and their potential impact

on the health and viability

of an industry which was traditionally

a heavily regulated industry.

In order to achieve this goal, the

study integrates both market-based and the accounting-based

risk

measures. This study addresses another pertinent question, namely,

the proliferation

of "off-balance

sheet" activities

and their

impact on the riskiness of banking institutions.

These activities

'/ Some critics point out that DIDMCA (1980) increased the

power of the Federal Reserve System (Fed) with respect to its

ability

to conduct monetary policy and therefore increased the

regulation on the financial institutions

(Allen and Wilhelm).

COMMERCIAL BANK’S OFF-BALANCE SHEET ACTIVITIES

1245

have allowed banks to avoid certain regulatory

costs such as

minimum reserve,

deposit

insurance,

and capital

adequacy

requirements.

While, some of the off-balance

sheet instruments

lead to risk reduction, others increase the risk exposure of the

commercial banks. Therefore, the overall impact of off-balance

sheet activities

on the riskiness of banking institutions

is an

important empirical question from the point of view of managers,

regulators, depositors, uninsured large depositors, investors, and

undiversified

investors.

The remaining sections are organized as follows.

The

literature

review is presented in the next section.

The research

hypotheses and methodology is discussed in section 3 while

discussion of results is provided in section 4. The paper gives

conclusion and implications

of the study in the final section.

2. Literature Review

2.1 Market Risk

Risk in the most general sense is defined for a class of

utility

functions held by risk avertors.

In an operational

sense,

risk illustrates

the notion of uncertainty or dispersion associated

with an outcome. In the CAPM framework, risk is measured by the

variance of possible returns. However, variance is not a universal

measure of riskiness.

The first definition

of risk is derived from the CAPM

framework. If the return generating process is described by the

following equation:

Where, gic is the i& banks holding period return in the month

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4TH AFIR INTERNATIONAL COLLOQUIUM

R
(1)

t, R;,
portfolio

represents the holding period return for in month t, and A, represents the svstematic

the market risk which

measures the security's

sensitivity

to market wide events which

cannot be diversified

away. Flannery and James (1984) and Kwan

(1991) report that interest rate volatility

has become a major

concern. interest

They found that a two index model with a proxy for both rate returns and market return may be the most appropriate

way to follows:

model

commercial

banks stock returns.

Their model is as

giit=a,, +p,,,,R~,+Pkil?kt+~iit

(2)

Where R:, is the i" banks holding period return in the month

t, R;,represents the holding period return for the market portfolio

in the month t, Rk, represents the holding period return on a proxy

for the risk-free

interest rates in month t, D, represents the

systematic risk which measures the security's sensitivity

to market

wide events, and 0, measures the effect of nominal interest rate

changes on bank stock returns, and Citiis the error term.

Similarly,

including a proxy for interest rate risk (Ri,)

,

the relationship

between total risk and the market-based measures

of both interest rate and market risk can be estimated by expanding

and taking variance of equation 2 as follows:

d (R:,) =P$02 (Rz,) +p%U” (Ri,) +Zp,ipkiCOV,R~,,

R-~,) +02 (Zi,) (3)

From equation (3) we can estimate total market risk o”(R:,) and

two measures of unsystematic risk: one related to short-term rates

COMMERCIAL BANK’S OFF-BALANCE SHEET ACTIVITIES

1247

and one for long-term rates [a21Cii,) 1. From equation (2) we derive

two measures of systematic

market risk: one estimated

in

conjunction

with short-term rates f&i,, the other estimated in

conjunction

with long-term rates C&) . Finally equation (2)

provides two measures of systematic interest rate risk: one for

short-term rates C&) , the other for long-term rates (Pii)

.

Thus, a total of seven risk measures reflecting

both systematic,

unsystematic,

and total risk generated by both market and interest

rate movements.

2.2 On-Balance Sheet Risk

In studies by Avery et al. (1988), Furlong (1988), Flannery

and James (1984), Jahankhani and Lynge (1980), Brewer and Lee

(19861, Flannery (1980), Whalen and Thompson (1988), Avery and

Belton (1987), and Saunders, Strock and Travlos (1990) a number of

on-balance sheet risk measures have been utilized.

There seems to

be a general consensus on the following accounting based risk

measures.

2.2.1 Gan (GAP)

In a number of studies2, it has been pointed out that interest

rate risk arises since the maturity composition of assets and

liabilities

may be different

and therefore banks may be affected

adversely,

as changing market interest

rates may have a

differentiated

impact on the value of assets and liabilities.

Sensitivity

of commercial bank stock returns can also be explained

'/ See for example studies by Stone (1974), Lynge and Zumwalt (1980), Chance and Lane (1980), Flannery and James (1984), Booth and Officer (1985), Aharony, Saunders, and Swary (1988), and Tarhan (1987).

4TH AFIR INTERNATIONAL COLLOQUIUM

by the nominal contracting hypothesis (French, Ruback, and Schwert

1983). Nominal contracts are those assets which have cash flows

that are fixed in nominal terms.

On the other hand, cash flows

generated by real assets fluctuate with the price level. Overall,

most of the assets and liabilities

of depository

financial

institutions

can be postulated to be nominal contracts.

Thus,

according to nominal contracting

hypothesis,

a firms holding of

nominal assets is important in order to achieve the objective of

maximizing stockholder's

wealth.

Studies by Fama (1975,1976),

Nelson and Schwert (1977), and Fama and Gibbons (1982), established

that unexpected changes in interest rate are directly related to

inflationary

expectations.

Hence, the nominal contracting

hypothesis

supports the notion that unanticipated

changes in

interest rate would affect a banks' equity value depending on the

duration of nominal assets and liabilities

held by the firm.

The

greater the amount of net nominal assets and the longer the

duration of these assets, the higher would be the interest rate

sensitivity

of bank's common stock. The measure used in this study

is the difference between interest rate sensitive assets subject to

repricing

and interest

rate sensitive

liabilities

subject to

repricing normalized by the book value of equity.

2.2.2 Credit Risk (CR)

Credit risk relates to the risk associated with the quality of

a bank's earning assets, namely its loans. Asset quality is also

the second component of a bank's CAMEL rating.

Since banks are

highly leveraged, Brewer and Lee (1986) contend that large non-

performing

loans or large security

losses can bring about

COMMERCIAL BANK’S OFF-BALANCE SHEET ACTIVITIES

1249

insolvency.

Furthermore, major fluctuations

in interest rates can

greatly influence the market value of long-term fixed rate assets.

Similarly,

a decline in asset quality can lead to writeoffs

and

reduced earnings from the loan portfolio.

The measure used in this

study is calculated by dividing loan loss provision with total

loans.

2.2.3 Capital Adeauacv Risk ICAPI)

This is the first component in the bank's CAMEL rating.

Capital provides a cushion to protect the position of creditors,

depositors,

regulators,

and insurers (FDIC) in the event of bank

failure.

Moulton (1987) advocates that bank capital provides a

stabilizing

influence on the risks faced by the banks. Hence, there

is a need to have some minimum level of capital.

The relationship

between capital levels and market index and interest rate measures

of risk is expected to be negative. The measure used in this study

is the book value of total capital divided by total assets.

2.2.4 wi

Liquidity

risk arises if the bank has to pay a premium over

market value in order to fund its assets (see Brewer and Lee 1986).

Beaver, Kettler, and Scholes (1970) argue that liquidity

risk is

reduced if a bank holds greater levels of current assets.

Evidently, current assets have less volatile return than long-term

assets. On the other hand, banks that have greater holdings of

short-term

liabilities

(deposits

and purchased funds),

are

potentially

exposed to liquidity

problems if asset quality

declines.

Jahankhani and Lynge (1980) measure liquidity

by taking

the ratio of cash and dues plus U.S. treasury securities

to total

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4TH AFIR INTERNATIONAL COLLOQUIUM

assets. The liquidity

variable used in this study is constructed

by taking the ratio of liquid assets net of liquid liabilities

to

total assets. Liquid assets include cash less required reserves,

federal funds sold, U.S. treasury securities,

and repurchase

agreements (repos). Liquid liabilities

include federal funds

purchased and reverse repurchase agreements.

2.2.5 Leveracre and Ooeratina Risk (OLEV & FLEV)

As indicated

by Beaver, Kettler,

and Scholes (1970), as

additional

debt is added the earnings stream of common stock

holders shows increased volatility.

Hamada (1972) reports that

approximately

one quarter of systematic risk is explained by the

degree of financial leverage. Whereas, Lev contends that operating

leverage as measured by fixed cost is the real determinant of the

systematic risk.

On the other hand, Mandelker and Rhee (1984)

find that both operating and financial leverage jointly determine

systematic risk. Therefore, if these leverage ratios increase, it

may lead to higher variability

of bank stock returns and therefore

its market risk. Financial leverage is constructed by taking a

ratio of total liabilities

and total assets while operating

leverage is the ratio of interest expense and interest income.

2.2.6 Manaaement Risk IMANGMT)

One of the important causes cited for increased riskiness of

banking firm relates to the insiders'

improprieties

(see for

example (Kummer, Arshadi, and Lawrence (1989)).

Furthermore, the

nature of the fixed rate deposit insurance premium which is similar

to the put option issued by the FDIC and held by insured banks,

provides incentive to the stockholders and managers to increase the
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