Question

Understanding the structure of commercial banks and the services/products that they provide is essential for the successful leadership of any commercial enterprise. While fundamental knowledge of the industry as a whole is important, it is equally crucial to assess the risk profile of counter-parties to ensure that appropriate steps have been taken to mitigate this risk as much as possible.

To understand the risk associated with corporate banking activities more, prepare a written response to the following questions:

• What is meant by off-balance sheet activity?
• What specific types of off-balance-sheet items would you expect for commercial banks?
• How does an off-balance-sheet item move onto the balance sheet?
• How do you assess the risk of off-balance-sheet items?

Answer 1

Off balance sheet activity means an asset or debt or financing activity that is not on the company’s balance sheet. Off balance sheet items, in other words, are assets or liabilities that do not appear on a company’s balance sheet.

For commercial banks the specific types of off-balance-sheet items that I would expect are guarantees and other similar contingent liabilities, commitments, market related transactions and lastly advisory, management and underwriting functions of commercial banks.

An off balance sheet item move onto the balance sheet when the concerned item becomes a direct obligation of the company and no longer remains an indirect obligation of the company.

To assess the risk of off-balance-sheet items one needs to adjust financial statements to recognize net liability and gains and losses of the off balance sheet entity. If a special purpose vehicle (SPV) is involved then both assets and liabilities of the SPV will have to be recognized by adjusting the financial statements. In case of pension obligations risk can be assessed by analyzing cash flows after considering future pension obligations.