Off-balance sheet banking - Essay Example

? Off-balance sheet banking Table of Contents Off-balance sheet banking with examples 3 Importance of controlling Off-Balance Sheet Banking and Role of Financial Regulators 5 Ways of controlling Off-Balance Sheet Banking by Financial Regulators 6 References 9 Off-balance sheet banking with examples Off-Balance Sheet, otherwise called Incognito Leverage is described as an asset or liability of a company which has no existence in the Balance sheet of the company. There are quite a few companies who have their assets or debts but the same is not included in the Balance sheet of the respective company. Let us explain this with an example. Asset Management services are often offered by financial institutions for brokerages to their customers for which they take securities from the respective companies. These securities are not to be considered by the financial institutions as their own assets. This is because the securities actually belong to the clients to whom the service is offered. The companies only play the role of managing the securities. For this reason, the companies or the financial institutions treat these securities or trust as Off-Balance sheet items (Ronen, Saunders and Sondhi, 1990, p.1). Banks treat their traditional loans as on-balance sheet items where they record the loans disbursed under their lending policies as assets in Balance sheet and also retain the credit risk for lending. On the other hand, securitization help banks in transferring the credit risk and treat the lending or assets as Off-balance sheet items. Bank discloses securitized assets in the form of notes in their financial statements. Let us explain Off-balance sheet banking with an example. Suppose a bank has a valued customer who maintains a deposit of one million dollars in his or her bank account. Thus the bank has a direct liability of one million dollars to its customer (Investing Answers, 2013, p.1). Now if the customer wants to invest this money in a money market fund that is run by the bank, the Bank would not treat it as its liability. The Bank would treat it as an amount held in trust for the client in the form of shares or units of the fund. Thus the amount would be shown by the bank as an Off-balance sheet item. In the same way if the money is used by the customer for buying stock, the Bank would not be liable for the stock value and hence would treat the amount as an Off-balance sheet item. On the other hand, if the customer sells the investment and again deposits the amount in the Bank account, it becomes a liability for the bank. For instance, Citibank maintain an off-balance sheet asset of 960 billion $ which accounts for 6% of the GDP of United States. The formal distinction between On & Off-Balance sheets is quite critical and depends largely on the decisions of management. In true sense, a company would include assets and liabilities in their balance sheet if it either actually owns or for which it is legally responsible. For including an asset or liability in the Balance sheet, the asset or liability has to be probable, measurable as well as meaningful. Otherwise, the financial company or the Bank would treat the assets or liabilities as Off-balance sheet items. For example, a Bank which is facing a legal issue due to non-fulfilment of its liabilities would not include the amounts in its balance sheet until a complete judgment is received, until the amount of compensation or recovery is delivered through judgment, or may include the risk in its balance sheet if it is negligible until the entire legal process is over. Importance of controlling Off-Balance Sheet Banking and Role of Financial Regulators Over the last thirty years, there has been a scenario of increasing crisis while the banks have increased their portfolio of Off-Balance sheet activity through securitization, mainly short term asset backed by commercial paper. This has produced linkage between the banking system and the shadow-banking system. Thus, the importance of regulation off-balance sheet banking by financial regulators is a very important issue. The shadow banking systems is mainly comprised of NBFCs or the Non-Banking Financial institutions which act in a similar way like the banks. Their lending policies though are not as tight as the traditional banks. Hence the increase in Off-balance sheet banking by the banks led to the financial crisis as return of investments fell unguaranteed leading to several defaults and bankruptcy (Thiemann, 2011, p.2). Ways of controlling Off-Balance Sheet Banking by Financial Regulators This situation fell out of proportion which ultimately led to huge loss in financial market and industry. The years 2007 – 2009 were affected by the subprime market loss as well as losses in mortgage market. Fall of Lehmann Brothers is an ideal example. Depositors not only withdrew money from their Bank accounts leading to sharp decline in deposit base of the banks but market investor also refused to invest in the share and stocks of the banks for which the share price of the banks fell steeply. This turmoil in the financial industry leads to increasing accountability for the financial regulators for controlling Off-Balance sheet banking. Regulators control Off-balance sheet activity of Banks in order to safeguard their solvency and maintain the health of the national economy. Banks are expected to keep their Off-balance sheet assets and liabilities within a safe limit and also diversify the risk of Off-balance sheet activity. Banks are required to do a portfolio analysis of their borrowers through securitization and the offer financing to the selected parties in order to hedge the risk (Greuning and Bratanovic, 2009, p.48). Financing to a single large customer would affect the solvency of the bank based on the projected performance and repayment of a single party. On the other hand, diversifying the asset would reduce the risk the Off-Balance sheet risk. Banks are expected to look at the viability of settlement of funds before lending in Off-Balance sheet items. This would reduce the settlement risk of the Banks. Banks should look into comprehensive country risk in terms of irrevocable commitments, contingent liabilities and foreign-exchange positions to reduce off Balance sheet risk (Partnoy and Turner, 2007, p.86). The role of the regulator is important in terms of engaging into dialogues with the bank and having an overall supervision to ensure that Bank implements and executes the appropriate procedures to measure and control the risk. Effective procedures adopted by Banks to control Off-Balance sheet banking include separation of function and sanctioning of exposure limits, auditing, risk control and appropriate information systems (RBI, 2013, p.18). References Greuning, H. V. and Bratanovic, S. B. 2009. Analyzing Banking Risk (3rd Edition): A Framework for Assessing Corporate Governance and Risk Management. World Bank Publications; Washington D.C. InvestingAnswers, Inc. 2013. Off-Balance-Sheet Financing. [Online]. Available at: http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/balance-sheet-financing-3890. [Accessed on 21 February, 2013]. Partnoy, F. and Turner, L. E. 2007. Bring Transparency To Off-Balance Sheet Accounting. [Pdf]. Available at: http://www.rooseveltinstitute.org/sites/all/files/Off-Balance%20Sheet%20Transactions.pdf. [Accessed on 21 February, 2013]. RBI. 2013. REGULATION OF OFF- BALANCE SHEET ACTIVITIES OF BANKS. [Pdf]. Available at: http://rbidocs.rbi.org.in/rdocs/notification/PDFs/RNDPC090110.pdf. [Accessed on 21 February, 2013]. Ronen, J., Saunders, C. A. and Sondhi, C. A. 1990. Off-Balance Sheet Activities. Greenwood Publishing Group; Westport USA. Thiemann, M. 2011. Regulating the off-balance sheet exposure of banks. [Pdf]. Available at: http://www.feps-europe.eu/uploads/documents/1106_OffBalanceSheetExposure_Thiemann.pdf. [Accessed on 21 February, 2013]. Read More