Lesson 9: Off-Balance-Sheet-Risk

Question 1

How does one distinguish between an off-balance-sheet asset and an off-balance-sheet liability?

Answer 1

Off-balance-sheet activities or items are contingent claim contracts.
An item is classified as an off-balance-sheet assetwhen the occurrence of the contingent event results in the creation of an on-balance-sheet asset. An example is
a loan commitment.
If the borrower decides to exercise the right to draw down on the loan, the FI will incur a new asset on its portfolio.

Similarly, an item is an off-balance-sheet liability when
the contingent event creates an on-balance-sheet liability. An example is a standby letter of credit
(SLC). In the event that the original payer of the SLC defaults, then the FI is liable to pay the amount to the payee, incurring a liability on the right-hand-side of its balance sheet.

Question 2

Contingent Bank has the following balance sheet in market value terms (in millions of dollars):

Assets ($M) Liabilities ($M)
Cash - 20 Deposits - 220
Mortgages - 220 Equity - 20
Total - 240 Total - 240

In addition, the bank has contingent assets with $100 million market value and contingent liabilities with $80 million market value. What is the true stockholder net worth? What does the term contingent mean?

Answer 2

Net worth = ($240m - $220m) + ($100m - $80m) = $40million.

The term contingentmeans an event that may or may not happen. In financial economics, the term is used in conjunction with the result given that some event does
occur.