Off-balance sheet activities refer to debt financing or even an asset financing activity that is not necessarily featured in the bank’s balance sheets. In other cases, it involves leases and other subsidiary liabilities to the bank. Off-balance sheets are commitments to a bank through loans that are got through the sale of issued securities and other facilities within a bank.
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In real terms, off-balance-sheet activities do not form liabilities to a bank but only hold its client’s securities as trust. Off-balance sheet activities usually involve asset management activities or even brokerage services to securities for their clients by banks. This is done when customers of regular banking services diversify their activities to involve trade in securities which often includes the transfer of the deposits held in their regular deposits accounts. Since banks only hold the securities as transfers for their clients, the bank is not liable (has no liability) and therefore such stocks would not appear in their balance sheets. (Stiroh 2006).
The assets will belong specifically to the clients in question while the banks will only provide management services, purchases, or other services like depository. For a bank, it cannot have a direct claim regarding these securities although they play an important role for its clients. Off-balance sheets activities do not form part of a balance sheet because are neither assets of a bank nor its liabilities.
Banks, however, earn income through varied reinstatement fees that the clients ought to pay for the processing of these transactions. Like any other banking activity that does directly involves the assets of a bank, these services help a bank to earn processing fees, depository, transactional and other charges. (Michael 1994).
Generally, off-balance activities relate to banking activities with the characteristics of generating income to the bank without primarily affecting or been reflected in the balance sheet.
Types of off-balance-sheet activities
There are many types of off-balance-sheet activities, whereby segmentation in some of them results in creating other forms of these activities.
Perhaps, securitization is one aspect. It refers to the purchase of securities as per the requirements of banks’ clients. However, since this does not directly involve an asset or liability of a bank, it will not be featured in the bank’s balance sheet. Elsewhere banks will act as trustees to their clients in the management of these assets (security). Banks will benefit from the varied fees that may be ascribed to trade transactions in the share on behalf of their clients. (Scholte, Schenabel 2002).
Also, loan sales form part of the off-balance sheet activities. For many banks, customers’ frequent deposits are loaned out to other clients or even institutions. Through such loans, banks acquire some benefits through the interest that accrue from such loans. In banks’ balance sheets their actual liabilities to their clients are reflected and include actual deposits and interests on such deposits. However, for the loans that are rented out to other clients on the bank client’s deposits, they are normally made to earn higher interest rates levy to the respective client’s deposits. (Hanaxaski, Teramishi, 2004) This difference in the interest rates between loaned out finances and whatever is paid to clients is however not reflected in banks’ balance sheets. Such a difference forms parts of the banks’ income generated from their operational activities. Banks’ transactional activities in the processing of such loans sales may have varied income for a bank which will ultimately not be reflected in its balance sheet.
Banks can also use standby letters to project off-balance sheet activities. This service helps clients to pledge for securities in their accounts through the use of collaterals, replacement of traditional deposits in their accounts with these securities, or use of decreasing payment on bonds. Going in line with these patterns the client’s accounts are possibly credited with such securities on a credit basis. (Krahen, Schimdt 2004). Clients will own securities credited to their account which will bear benefits in the process of market capital trade transactions of securities. A client repays such security cost to the bank getting the overall benefits that may have accrued in the trade on the securities. A bank will not reflect these securities in its balance sheet because they are not derived from its assets and liabilities. In the transactional system of these issues, the bank will develop income through fees that are connected with its credit security trading (Richardson, Robert 1999).
In Australia, the establishment of the Australian Accounting Standard Board has affected the off-balance-sheet activities in a quite substantial way. These changes had been implemented by statute 139 (AASB 139) of these standards. With its regulation of accounting standards, this act has structured the requirements of the off-balance-sheet transactions to involve more legalized protocols that reflect the rights of individuals in such a system. It enacts various regulations that sanction the promotion of high standards in off-balance-sheet activities. Specifically, about Australian financial systems, AASB 139 has elaborated different activities of both market and non-market off-balance activities. Within the structure of AASB 139 different foundations have been laid out to reflect how banking institutions should deal with their clients’ realization of any off-balance sheet activities. (ACT AIFRS 2005) It also has set the basic standard by which banks should follow so as not to exploit their clients for their benefit. The same act has established the specific rights and responsibilities for these banks and their clients. AASB 139 will need financial assets to be duly recognized when a certain entity is a party in the contractual provision of financial instruments. According to AASB, 139 financial assets are classified into the following categories (ACT AIFRS 2005):
- Financial assets in Fair Value using Profit and Loss;
- Investments held-to-maturity;
- Receivables and loans;
- Financial assets are available for sale.
Depending on their nature off-balance sheet activities may not be based on the market parameters. Such activities would not be influenced by activities in the money market and therefore their foundations are unlimited to the trends in the market system. (Chambliss, Block 2004).
However, depending on the nature of off-balance activities they can still be named as non-market based off balance activities.
A bank can use market securitization when it purchases securities on behalf of clients in other organizations for mere shareholder purposes. Interest is not to be traded in the market capital system by the client but he may occasionally choose to become a shareholder in such organizations. (Hiroshi, Toshiaki 2001).
Non-market loan sales when banks give loans of non-capital nature to other clients based on the frequent deposits of their clients. Such loans will not be subject to trade factors within the market system which may dictate certain structural regulations on them. (Stiroh 2006, Hood 1998).
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Some standby letters may be mere guarantees that a bank may hold as a trust to its clients about transactional activities that may not possibly be of the market origin. For instance when a bank offers a guarantee to another institution on behalf of their clients in which the credit transactions are not securitized. In all aspects, the common off-balance activities can be treated as non-market-based activities depending on the nature of transactions involved which could not be of market nature. (Bauman 2003).
Contingent liabilities should be regarded as an important type of off-balance-sheet activity. According to Schnee (2004), off-balance-sheet contingent liabilities involve guarantees (sureties), credit lines, letters of credit, overdrafts, and unused credit cards. Contingent liabilities are different from ordinary loans and credits and they assume various liquidity and interest rate challenges and risks. For instance, letters of credit are widely used by Australian banks as they provide high profits however they are risky since documents and client’s liabilities should be accurately studied. Guarantees also contain many risks since it is an independent obligation, regardless of certain relations tied with principal debts or agreements concluded between a creditor and a principal debtor.
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