Off-balance-sheet (OBS) activities refer to activities that are not recorded on the balance sheet of a bank but affect the bank's financial status and risk profile. OBS activities can both generate income and expose the bank to various risks.
Some of the common types of off-balance-sheet activities we regularly perform in IFB:
Derivatives and Hedging Activities: These are instruments whose value is derived from underlying assets, liabilities, or indices. Common derivatives include futures, options, swaps, and forward contracts. They are used for speculation, hedging, and arbitrage. For example, a bank might use a currency swap to hedge against exchange rate risk. The potential gains and losses from these activities do not appear on the balance sheet until they are realized, but they can be significant.
Loan Commitments: These are agreements by a bank to provide a loan at a future date under specified terms. The bank does not record a loan on its balance sheet until it disburses the funds. However, the commitment can still expose the bank to risk significantly if the borrower's creditworthiness deteriorates before the loan is paid.
Letters of Credit and Financial Guarantees: These are promises by a bank to make payment to a third party if a specific event occurs. For example, a bank might issue a letter of credit guaranteeing payment to a supplier if the bank's client fails to pay. These instruments can create contingent liabilities for the bank that are not recorded on the balance sheet.
Securitization and Asset-Backed Securities: In a securitization transaction, a bank might pool loans or other assets and sell them to a special purpose entity (SPE), which then issues securities backed by the cash flows from the assets. The SPE is usually not consolidated with the bank for financial reporting purposes, so the assets and liabilities of the SPE do not appear on the bank's balance sheet. However, if the bank provides credit enhancements or liquidity support to the SPE, it can expose the bank to risk.
Sale and Repurchase Agreements (Repos): A repo is a transaction in which one party sells a security to another party with an agreement to repurchase it at a specified price on a specified date. For the seller, a repo is effectively a short-term loan with the security serving as collateral. From a balance sheet perspective, the seller usually continues to recognize the security as an asset and records a liability for the repurchase obligation.
Trust and Custodial Activities: Banks often act as trustees or custodians, holding assets on behalf of clients. These assets do not belong to the bank and are not recorded on its balance sheet, but the bank may earn fees for providing these services.
While these off-balance-sheet activities can provide banks with additional sources of income and ways to manage risk, they can also expose banks to significant risks. These risks can include credit risk (the risk of loss from a borrower's failure to repay a loan), market risk (the risk of loss from changes in market prices), operational risk (the risk of loss from inadequate or failed processes, people, and systems), and legal risk (the risk of loss from litigation or non-compliance with laws and regulations).