Question

Discuss the importance of disclosing contingent assets and contingent liabilities for a financial institution. How can these contribute to a bank collapse?

Answer 1

A contingent asset is a possible asset that may arise because of a gain that iscontingent on future events that are not under an entity's control. According to the accounting standards, a business does not recognize a contingent asset even if the associated contingent gain is probable.

A contingent liability is a potential liability that may or may not occur depending on the result of an uncertain future event. The relevance of a contingent liability depends on the probability of the contingency becoming an actual liability, its timing, and the accuracy with which the amount associated with it can be estimated.

A contingent liability is recorded in the accounting records if the contingency is probable and the related amount can be estimated with a reasonable level of accuracy. The most common example of a contingent liability is a product warranty. Other examples include guarantees on debts, liquidated damages, outstanding lawsuits, and government probes.

A balance sheet analysis may suggest that a company has low debt and few liabilities but it all depends on how the finance is classified. Measures to keep reported capital levels as low as possible (for example to improve debt to equity ratios), will often include financing that does not have to be reported in the balance sheet – the result of which is an incomplete corporate picture.

OBS techniques can be used for a variety of reasons, including managing or mitigating the exposure to particular risks or reducing borrowing costs.

In fact, OBS funding lowers the cost of borrowing if lenders are not aware of the unrecorded liabilities and it avoids violating some debt covenants – the restrictions specified in the debt agreement to protect the lender. These restrictions are sometimes stated in the form of financial ratios which may be affected by whether or not the liability is recorded.

Therefore, these methods can affect key financial ratios, especially the financing ratios that use total debt as a denominator, showing them to be lower (and more favourable) than they would be if the financing were recognised.

Risks of OBS transactions

While it is not difficult to understand why OBS transactions are popular, they have their risks. While OBS is performed by many companies for the reasons set out above – risk management and reduction of borrowing costs – the position expressed by Anthony Love, Jennifer Shotwell, and T. J. Henderson, in their article ‘Off-Balance-Sheet Activities and Their Related Risk’4, helpfully summarises the main risks:

1. There is a risk to the company carrying out the transaction. If a company has too many OBS transactions, and at the same time management is highly dependent or focused on the numbers in the financial statement, it can perceive the company’s financial health to be greater than it really is.

2. It is important to consider the perception that is passed to the users of financial statements. While financial institutions and major investors are aware of the presence and influence of OBS disclosures, many other financial statement users may not be. When professionals evaluate the financial statements of a company, they almost always dissect the disclosures related to OBS transactions and add them back to the balance sheet to arrive at a more realistic statement of position. Other financial statement users may not be as equipped with the detailed financial and accounting knowledge to do the same. This could lead to a misinterpretation by the user and possibly a bad investment in, or relationship with, the company.

3. OBS activities may present a risk to the company’s certified public accountants (CPAs). Here, we can take a step back and point to the dissolution of worldwide group Arthur Andersen as a result of the Enron scandal.5 CPAs should be provided with as much knowledge as possible about all of the company’s OBS activities to ensure their proper disclosure in the financial statements, and consequently, an accurate opinion on the audit report.

Example off-balance sheet scenarios

Scenario 1:Client risk assessment

You are a banker with a corporate client asking EUR1m of funding. Before deciding to make this loan, you analyse the balance sheet and you see no relevant liabilities. Does that mean the credit risk for this client is good?

What if you analyse the remaining financial statements and stumble upon a note mentioning a EUR2m leverage associated with a joint venture in technical bankruptcy? Should you be worried? Does it even matter when it comes to deciding whether, or not, you should go ahead and grant the client’s requested funding? Should this liability affect the client’s credit risk?

Scenario 2: Letters of credit

A different corporate client approaches you and mentions he intends to buy goods from another company. This company is requesting a guarantee that the client will pay for the goods so your client asks you to issue a letter of credit. At first glance, you see no objection. Should there be any?

Scenario 3: Selling down liabilities

Your bank needs to reduce balance sheet liabilities to comply with the most recent Basel requirements 1. But liabilities don’t just go away and you’re on the team incorporated to come up with ways to make it happen.

Then, it occurs to you; why not sell some of the liabilities to a fund? Problem solved and fewer liabilities ?for the bank, better leverage and ?capital ratios. Should there be any reason for concern?

For all three of these scenarios the answer is ‘yes’. They demonstrate some of the many forms of OBS funding. In each case, there are advantages but also risks for all parties involved.

In the first one, if you hadn’t seen the note in the financial statements, you could have granted a perfect credit risk along with a EUR1m loan to a client that may be on the verge of having to cope with a EUR2m responsibility.

In the second and third situations, you contributed to increase the banks’ leverage and capital ratios but also to create additional potential exposures which are not obvious unless you know where to look