Off-balance-sheet
- Introduction
Off-balance sheet activities encompass a variety of items including certain loan commitments, certain letters of credit, and revolving underwriting facilities. Additionally, swaps, futures, forwards, and option contracts are derivative instruments whose notional values are carried off-balance sheet, but whose fair values are recorded on the balance sheet. Examiners reviewing off-balance sheet derivative contracts will find resources such as the Capital Markets Handbook, the Consolidated Reports of Condition and Income (Call Report) Instructions, Senior Capital Markets Specialists, and capital markets and accounting subject matter experts helpful.
Off-balance sheet fee producing activities can improve earnings ratios, at a faster pace than on-balance sheet fee producing activities. Earnings ratios typically use assets as a component. Since earnings generated from these activities are included in income, while total asset balances are not affected, ratios appear higher than they would if the income was derived from on-balance sheet activities. Because these types of activities remain off the balance sheet, capital to asset ratios (with the exception of risk-based capital ratios) are not adversely affected regardless of the volume of business conducted. But, the volume and risk of the off-balance sheet activities needs to be considered by the examiner in the evaluation of capital adequacy. Regulatory concern with off-balance sheet activities arises since they subject a bank to certain risks, including credit risk. Many of the risks involved in these off-balance sheet activities are indeterminable on an offsite-monitoring basis.
- Explanation
Definition of Off-balance-sheet
Off balance-sheet in fact, has many meaning, some of the definitions are:
1. Off balance sheet (OBS) usually means an asset or debt or financing activity not on the company's balance sheet. It could involve a lease or a separate subsidiary or a contingent liability such as a letter of credits. It also involves loan commitments, futures, forwards and other derivatives except such derivatives pertaining to equity securities, ESOP, or phantom stock, which usually must be held as reserves in the Long Term Debt section of a Balance Sheet when-issued securities and loans sold.
2. A form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.
3. The business activities of a savings association that generally do not involve booking assets (loans) and taking deposits. Off-balance sheet activities normally generate fees, but produce liabilities or assets that are deferred or contingent and thus, under GAAP, do not appear on the institution's balance sheet until or unless they become actual assets or liabilities with a value or cost that can be determined. Examples include guarantees substituting the institution's own credit for a third party such as in standby letters of credit; interest rate swaps; foreign exchange forward options; repurchase agreements; loan commitments; and recourse associated with sales of assets.
Those are some definition of Off-balance-Sheet. In fact, this case is not only occurred in bank. But also others institutions, such as in a company or other organization.
The example which is occurred in a bank, such as: A bank may have substantial sums in off-balance sheet accounts, and the distinction between these accounts may not seem obvious. For example, when a bank has a customer who deposits $1 million in a regular bank deposit account, the bank has a $1 million liability. If the customer chooses to transfer the deposit to a money market mutual fund account sponsored by the same bank, the $1 million would not be a liability of the bank, but an amount held in trust for the client (formally as shares or units in a form of collective fund). If the funds are used to purchase stock, the stock is similarly not owned by the bank, and do not appear as an asset or liability of the bank. If the client subsequently sells the stock and deposits the proceeds in a regular bank account, these would now again appear as a liability of the bank (although the same funds held in a brokerage account may or may not be off-balance sheet). However, it's been argued that the contrary is also feasible.
The Off Balance-Sheet activities are involved as below,
Off-Balance Sheet Lending Activities
An evaluation of off-balance sheet lending activities should apply the same general examination techniques that are used in the evaluation of a direct loan portfolio. For example, banks with a material level of contingent liabilities should have written policies addressing such activities adopted and approved by their board of directors. The policies should cover credit underwriting standards, documentation and file maintenance requirements, collection and review procedures, officer and customer borrowing and lending limits, exposures requiring committee or board approval, and periodic reports to the board of directors. Overall limits on these contingent liabilities and specific sub-limits on the various types of off-balance sheet lending activities, either as a dollar amount or as a relative percentage (such as a percent of total assets or capital), should also be considered.
In reviewing individual credit lines, all of a customer's borrowing arrangements with the bank (e.g., direct loans, letters of credit, and loan commitments) should be considered. Additionally, many of the factors analyzed in evaluating a direct loan (e.g., financial performance, ability and willingness to pay, collateral protection, future prospects) are also applicable to the review of such contingent liabilities as letters of credit and loan commitments. When analyzing these off-balance sheet lending activities, examiners should evaluate the probability of draws under the arrangements and whether an allowance adequately reflects the risks inherent in off-balance sheet lending activities. (Such allowances should not be included in the allowance for loan and lease losses (ALLL) since off-balance sheet items are not included within the scope of FAS 5 and 114.) Allowances for off-balance sheet items should be made to "Other liabilities." Consideration should also be given to legal lending limits, including the provision of Part 337 of the FDIC Rules and Regulations, which generally requires standby letters of credit to be included when determining any legal limitation on loans to one borrower.
Letters of Credit
A letter of credit is a document issued by a bank on behalf of its customer authorizing a third party to draw drafts on the bank up to a stipulated amount and with specified terms and conditions. The letter of credit is a conditional commitment (except when prepaid by the account party) on the bank's part to provide payment on drafts drawn in accordance with the document terms. There are four basic types of letters of credit: travelers, those sold for cash, commercial, and standby.
Travelers – A travelers letter of credit is addressed by the bank to its correspondents authorizing drafts by the person named in accordance with specified terms. These letters are generally sold for cash.
Sold for Cash – When a letter of credit is sold for cash, the bank receives funds from the account party at the time of issuance. This letter is not reported as a contingent liability, but rather as a demand deposit.
Commercial – A commercial letter of credit is issued specifically to facilitate trade or commerce. Generally, drafts will be drawn when the underlying transaction is consummated as intended. Commercial letters of credit not sold for cash do, however, represent contingent liabilities and should be accorded examination treatment as such. Refer to the International Banking section of this Manual for further details on commercial letters of credit.
Standby – A standby letter of credit (SBLC) is an irrevocable commitment on the part of the issuing bank to make payment to a designated beneficiary. It obligates the bank to guarantee or stand as surety for the benefit of a third party. SBLCs can be either financial-oriented, where the account party is to make payment to the beneficiary, or performance-oriented, where a service is to be performed by the account party. SBLCs are issued for a variety of purposes, such as to improve the credit ratings for issuers of industrial development revenue bonds and commercial paper; to provide back-up facilities for loans granted by third parties; to assure performance under construction and employment contracts; and to ensure the account party satisfies financial obligations payable to major suppliers or under tax shelter programs.
Loan Commitments
A formal loan commitment is a written agreement, signed by the borrower and lender, detailing terms and conditions under which a loan of up to a specified amount will be made. The commitment will have an expiration date and, for agreeing to make the accommodation, the bank may require a fee to be paid and/or require the maintenance of a stipulated compensating balance by the customer. A commitment can be irrevocable, like an SBLC facility, operating as an unconditional guarantee by the bank to lend when called upon to do so by the customer. In many instances, however, commitments are conditioned on the maintenance of a satisfactory financial standing by the customer and the absence of default in other covenants. A bank may also enter into an agreement to purchase loans from another institution, which should be reflected as off-balance sheet items, until the sale is consummated. Loan commitments intended for sale are covered under Mortgage Banking later in this Section.
Some commitments are expected to be used, such as a revolving working capital line for operating purposes or a term loan facility wherein the proceeds will be used for such purposes as equipment purchases, construction and development of property, or acquisitions of other companies. Other commitments serve as backup facilities, such as for a commercial paper issue, whereby usage would not be anticipated unless the customer was unable to retire or roll over the issue at maturity.
Off-Balance Sheet Asset Transfers, such are:
Assets Sold Without Recourse
Assets (including loans) sold without recourse are generally not a contingent liability. In the case of participations, the bank should reflect on the general ledger only that portion of participated loans it retained. However, some banks may follow the practice of repurchasing loan participations and absorbing any loss on such loans even when no legal responsibility exists. It is necessary to determine management's attitude toward repurchasing these assets in order to evaluate the degree of risk involved. Contingent liabilities may result if the bank, as seller of a loan participation without recourse, does not comply with participation and/or loan agreement provisions. Noncompliance may result from a number of factors, including failure on the part of the selling institution to receive collateral and/or security agreements, obtain required guarantees, or notify the purchasing party of default or adverse financial performance on the part of the borrower. The purchaser of the participation may also assert claims against the bank on the basis that the financial information relied upon when acquiring the loan was inaccurate, misleading, or fraudulent and that the bank as a seller was aware of this fact. Therefore, a certain degree of risk may in fact be evident in participation loans sold without recourse. Examiners need to be mindful of this possibility and the financial consequences it may have on the bank. Further discussion of loan participations is contained in the Loans section of this Manual.
Assets Sold With Recourse
Assets transferred in transactions that do not qualify as sales under GAAP remain as balance sheet assets. For example, loan transfers that do not qualify for sale treatment would remain on the balance sheet and the proceeds raised from transfer are reflected as a secured borrowing with pledge of collateral.
Recourse and Direct Credit Substitutes
A recourse obligation or direct credit substitute typically arises when an institution transfers assets in a sale and retains an obligation to repurchase the assets or absorb losses due to a default of principal or interest or any other deficiency in the performance of the underlying obligor or some other party. Recourse may also exist implicitly where a bank provides credit enhancement beyond any contractual obligation to support assets it sold.
Off-Balance Sheet Contingent Liabilities, such are:
Asset-Backed Commercial Paper Programs
Asset-backed commercial paper programs are usually carried out through a bankruptcy-remote, special-purpose entity, which generally is sponsored and administered by a bank to provide funding to its corporate customers. Some programs will qualify for consolidation onto a bank's general ledger. For programs that are not consolidated, a bank should report the credit enhancements and liquidity facilities it provides to the programs as off-balance sheet liabilities.
Bankers Acceptances
The following discussion refers to the roles of accepting and endorsing banks in bankers acceptances. It does not apply to banks purchasing other banks' acceptances for investment purposes, which is described in the Other Assets and Liabilities section of this Manual. Bankers acceptances may represent either a direct or contingent liability of the bank. If the bank creates the acceptance, it constitutes a direct liability that must be paid on a specified future date. If a bank participates in the funding risk of an acceptance created by another bank, the liability resulting from such endorsement is only contingent in nature. In analyzing the degree of risk associated with these contingent liabilities, the financial strength and repayment ability of the accepting bank should be taken into consideration. Further discussion of bankers acceptances is contained in the International Banking section of this Manual under the heading Forms of International Lending.
Revolving Underwriting Facilities
A revolving underwriting facility (RUF) (also referred to as a note issuance facility) is a commitment by a group of banks to purchase at a fixed spread over some interest rate index, the short-term notes that the issuer/borrower is unable to sell in the Euromarket at or below this predetermined rate. In effect, the borrower anticipates selling the notes as funds are needed at money market rates, but if unable to do so, has the assurance that credit will be available under the RUF at a maximum spread over the stipulated index. A lead bank generally arranges the facility and receives a one-time fee, and the RUF banks receive an annual commitment or underwriting fee. When the borrower elects to draw down funds, placement agents arrange for a sale of the notes and normally receive compensation based on the amount of notes placed. The notes usually have a maturity range of 90 days to one-year and the purchasers bear the risk of any default on the part of the borrower. There are also standby RUFs, which are commitments under which Euronotes are not expected to be sold in the normal course of the borrower's business.
Adversely Classified Contingent Liabilities
For examination purposes, Category I contingent liabilities are defined as those which will give rise to a concomitant increase in bank assets if the contingencies convert into actual liabilities. Such contingencies should be evaluated for credit risk and if appropriate, listed for Special Mention or subjected to adverse classification. This examination treatment does not apply to Category II contingent liabilities where there will be no equivalent increase in assets if a contingency becomes a direct liability. Examination treatment of Category II contingencies is covered under Contingent Liabilities in the Capital section of this Manual.
3. Conclusion
From the short explanation of Off-Balance-Sheet above, we can take some of the summary about this case as following,
The balance sheet of commercial bank can be thought of as a list of the sources and uses of bank funds. The banks liabilities are its sources of fund, which include checkable deposits, time deposits, discount loan from The Fed, borrowing from other banks and corporation and bank capital. The bank’s assets are its uses of funds, which included reserves, cash item in process of collection, deposit as other banks, securities, loan, and other assets.
Off-balance-sheet activities consists of trading financial instrument and generating income from fees and loan sales, all of which affect bank balance sheet because of these Off-balance-sheet activities expose banks to increased risk, bank management must pay particular attention to risk assessment producers and internal control to restrict employees from taking on too much risk.
RSS Feed (xml)
