What is Off-Balance Sheet Exposure ?

Assets or liabilities not included on a company’s balance sheet are known as off-balance sheet items. Off-balance-sheet items are contingent assets or liabilities such as unused commitments, letters of credit, and derivatives. These items may expose institutions to credit risk, liquidity risk, or counterparty risk, which is not reflected on the sector’s balance sheet. Off-balance-sheet exposures should be included in a systematic manner in banks’ internal counterparty limits. A cautious approach to counterparty exposure measurement is appropriate since the objective is to limit the impact that the failure of a single customer might have on a bank’s solvency.

Off-balance sheet exposures also refer to activities that are effectively assets or liabilities of a company but do not appear on the company’s balance sheet. The off-balance sheet exposures in banking activities refers to activities that do not involve loans and deposits but generate fee income to the banks. The non-fund based facilities like Issuance of letter of guarantee, letter of credit, deferred payment guarantee, letter of comfort; Investments of clients held by an investment company etc. which are contingent in nature are some of the examples off -balance sheet exposures of the banks. The above mentioned items do not appear on the institution’s balance sheet until and unless they become actual assets or liabilities. Nevertheless, off-balance sheet items are detectable as they are appearing in the notes to financial statement of the organization. As per generally accepted accounting principles (GAAP) require an organization to disclose these and financing arrangements in the notes to their audited financial statements.

Leasing is the oldest form of off-balance sheet financing. Leasing an asset, allows the company to avoid showing financing of the asset from its liabilities and lease or rent is directly shown as an expense in the Profit & Loss statement. However, the latest accounting standard is to allow fewer and fewer off balance sheet transactions. For instance, a recent revision to the leasing standards now requires the recordation of an asset in use for certain types of lease obligations that previously would not have appeared in the balance sheet. Only Operating leases qualify as off-balance sheet financing and financial leases are required to be capitalised on the balance sheet as per latest Indian Accounting Standards. Special purpose vehicles or subsidiary companies are one of the routine ways of creating off the balance sheet financing exposures.