Off-balance sheet Activities and Their Risk

Off-balance sheet risk refers to the risk associated with contingent assets and liabilities. Contingent asset or liability denotes that an item that becomes an asset or liability depending on the occurrence of future event. For example, if the company has a loan commitment of borrowing $10 million from a bank, the event becomes the liability only when the company decides to borrow the money. 

 

Off-balance sheet Activities and Their Risk

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The off-balance-sheet activities include the following: 

Loan commitments: They refer to the pre-assigned commitments of loans to borrowers. The risk associated with loan commitments include interest rate risk, take down risk, credit risk and agreement funding risk. Interest rate risk indicates the fluctuations in interest rates. Take down risk occurs when the borrowers take the full amount that is committed by the loan provider. This may lead to liquidity risk in future. Credit risk is associated with the change of borrower over the loan period. Sometimes, large borrowing firms take multiple loans to cover their commitments and insure against the future credit scarcity. Often FIs face problem in raising capital to meet the commitments of their borrowers. This is known as agreement funding risk. 

Letters of Credit: Letters of credit refer to the payment guarantee given by an FI to a certain party. Letters of Credit are two types: Commercial letters of credit (CLC) that are related to trade and Standby letter of credit (CLC) that may not be related to trade. 

Derivatives: Derivatives are the financial assets. The value of these are determined by the value of underlying assets behind them. Credit Default Swap (CDS) is one of the risks associated with derivatives. They use credit derivatives which allow them prevaricating credit risk.

Forward Purchases/Sales:  Sometimes, FIs commit to buy or sell securities before the issue date which is known as ‘when issued’ trading of Securities. On the issue date the price can be either more or less than the price paid by the FIs. If the issue price is less that means the FI has purchased the securities at a more price which is a loss for them. 

Loans Sold: Often the loans given by FIs are not held till the maturity date. Rather the loans are sold to outside investors with recourse. They sold with recourse to keep their brand name. But such situations increase the risk as these loans leave long-term credit risk on those FIs.