Section 3.8 Off-Balance Sheet Activities

OFF-BALANCE SHEET ACTIVITIES Section 3.8

RMS Manual of Examination Policies 3.8-1 Off-Balance Sheet Activities (6/19)

Federal Deposit Insurance Corporation

INTRODUCTION .................................................................................. 2

OFF-BALANCE SHEET LENDING ACTIVITIES ............................. 2

Letters of Credit ................................................................................. 2

Loan Commitments ............................................................................ 3

TRANSFERS OF FINANCIAL ASSETS ............................................. 4

Mortgage Banking .............................................................................. 4

Financial Assets Sold Without Recourse ........................................... 5

Financial Assets Sold With Recourse ................................................ 5

Recourse and Direct Credit Substitutes .............................................. 5

OFF-BALANCE SHEET CONTINGENT LIABILITIES ..................... 5

Bankers Acceptances.......................................................................... 5

Revolving Underwriting Facilities ..................................................... 6

Standby LOC Issued By Another Depository Institution ................... 6

ADVERSELY CLASSIFIED CONTINGENT LIABILITIES .............. 6

OFF-BALANCE SHEET ACTIVITIES Section 3.8

Off-Balance Sheet Activities (6/19) 3.8-2 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

INTRODUCTION

Off-balance sheet activities include items such as loan

commitments, letters of credit, and revolving underwriting

facilities. Institutions are required to report off-balance

sheet items in conformance with Call Report Instructions.

The use of off-balance sheet activities may improve

earnings ratios because earnings generated from the

activities are included in the income numerator, while the

balance of total assets included in the denominator remains

unchanged.

Examiners should review the risks and controls associated

with off-balance sheet activities during examinations.

Reviews should consider the adequacy of items such as:

• Policies, practices, and internal controls;

• Conformance with applicable laws and internal bank

guidelines;

• Credit quality and collectability of off-balance-sheet

credit items; and

• Board oversight and audit activities.

←

OFF-BALANCE SHEET LENDING

ACTIVITIES

When reviewing off-balance sheet lending activities,

examiners should apply the same general examination

techniques they use when evaluating a direct loan

portfolio. For example, examiners should consider the

adequacy of internal controls and board-approved policies

at banks with a material level of off-balance sheet lending

activities. Comprehensive policies generally address

issues such as underwriting standards, documentation and

file maintenance requirements, collection and review

procedures, officer lending limits and customer borrowing

limits, board and loan committee approval requirements,

and board reporting requirements. Generally, overall

limits on contingent liabilities and specific sub-limits on

various types of off-balance sheet lending activities, either

as a dollar amount or as a relative percentage (such as a

percent of total assets or capital), are also often addressed.

When evaluating individual credit lines, examiners should

review all of a customer's borrowing arrangements with

the bank (e.g., direct loans, letters of credit, and loan

commitments). Other factors analyzed during direct loan

reviews, such as collateral protection and the borrower’s

financial condition, repayment history, and

ability/willingness to pay are also applicable when

reviewing contingent liabilities such as letters of credit and

loan commitments.

When analyzing off-balance sheet lending activities,

examiners should evaluate the probability that lines will be

funded and, if applicable, whether loss allowances

adequately reflect off-balance sheet credit risks. Such

allowances should not be included as part of the general

allowance for loan and lease losses (ALLL). Credit

exposures on financial instruments with off-balance sheet

credit risk should be recorded separate from the ALLL

related to a recognized financial instrument (i.e., an on-

balance sheet financial asset). Allowances for off-balance

sheet credit exposures are reported in Call Report Schedule

RC-G - Other Liabilities.

Examiners should also consider standby letters of credit

when determining legal limitations on loans to one

borrower and compliance with Section 337.2(b) of the

FDIC Rules and Regulations.

Letters of Credit

A letter of credit (LOC) is a document issued by a bank on

behalf of its customer authorizing a third party to draw

drafts on the bank up to a stipulated amount under specific

terms and conditions. A letter of credit is a conditional

commitment (except when prepaid by the account party)

on the bank’s part to pay drafts drawn in accordance with

the document’s terms. There are four basic types of letters

of credit: travelers, sold for cash, commercial, and standby.

Travelers – A travelers letter of credit is addressed by the

bank to its correspondents authorizing drafts by the person

named in accordance with specified terms. These letters

are generally sold for cash.

Sold for Cash – When a letter of credit is sold for cash,

the bank receives funds from the account party at the time

of issuance. This letter is not reported as a contingent

liability, but rather as a demand deposit.

Commercial – A commercial letter of credit is issued to

facilitate trade or commerce. Generally, drafts are drawn

upon when the underlying transaction is consummated as

intended. Commercial letters of credit not sold for cash

represent contingent liabilities. Refer to the International

Banking section of this Manual for further details on

commercial letters of credit.

Standby – A standby letter of credit (SBLC) is an

irrevocable commitment on the part of the issuing bank to

make payment to a designated beneficiary. Payments to a

beneficiary are guaranteed in exchange for an ongoing,

periodic fee throughout the life of the letter. An SBLC can

be either financial-oriented, where the account party is to

make payment to the beneficiary, or performance-oriented,

where a service is to be performed by the account party.

SBLCs are issued for a variety of purposes, such as to

OFF-BALANCE SHEET ACTIVITIES Section 3.8

RMS Manual of Examination Policies 3.8-3 Off-Balance Sheet Activities (6/19)

Federal Deposit Insurance Corporation

improve the credit rating of a beneficiary, to assure

performance under construction contracts, and to ensure

the beneficiary satisfies financial obligations payable to

major suppliers.

ASC Topic 460, Guarantees, clarifies that a guarantor is

required to recognize, at the inception of a guarantee, a

liability for the fair value of the obligation undertaken in

issuing the guarantee. ASC Topic 460 applies to standby

letters of credit, both financial and performance.

Commercial letters of credit and other loan commitments,

commonly thought of as funding guarantees, are not

included in the scope of ASC Topic 460 because those

instruments do not guarantee payment of a money

obligation and do not provide for payment in the event of

default by the account party.

While no particular form is required, SBLC documents

generally contain certain descriptive information. The first

item generally includes a separate binding agreement

wherein the account party agrees to reimburse the bank for

any payments made under the SBLC. The actual letter is

often labeled as a standby letter of credit, specifies a

stipulated amount, covers a specific period, and details

relevant information that must be presented to the bank

before any draws will be honored due to the account

party's failure to perform. Most SBLCs are carefully

worded so that the bank is not involved in making any

determinations of fact or law at issue between the account

party and the beneficiary.

The primary risks relative to SBLCs are credit risk (the

possibility of default on the part of the account party), and

funding risk (the potential inability of the bank to fund a

large draw from normal sources). An SBLC is a potential

extension of credit and should be evaluated in a manner

similar to direct loans. The credit risk could be significant

under an SBLC given its irrevocable nature, especially if

the SBLC is written for an extended period. Generally, a

bank can rescind a direct loan commitment to a customer if

the customer’s financial condition deteriorated and the

loan commitment contained an adverse-change clause.

However, such would not be applicable with an SBLC

since it is an irrevocable agreement between the bank and

the beneficiary.

An SBLC can be participated or syndicated. Unlike loans,

however, the sale of SBLC participations does not

diminish the total contingent liability of the issuing bank.

The name of the issuing bank is on the actual letter of

credit, and the bank must therefore honor all drafts

whether or not the participants are willing or able to

disburse their pro rata share. Syndications, on the other

hand, represent legal apportionments of liability. If one

bank fails to fulfill its obligation under the SBLC, the

remaining banks are not liable for that bank's share.

Section 337.2(d) of the FDIC Rules and Regulations

requires banks to maintain adequate controls and

subsidiary records of SBLCs, comparable to records

maintained on direct loans, so that a bank's total liability

may be determined at all times. Banks are also required to

reflect all SBLCs on published financial statements.

Consistent with Section 337.2(d) credit files should reflect

the current status of SBLCs, and adequate reports

regarding the types and volume of SBLCs should be

maintained. These reports enable management and the

board to monitor credit risks and identify potential

concentrations so that appropriate action can be taken, if

needed, to reduce undue exposure.

Examiners should assess the need to adversely classify or

designate as Special Mention an SBLC if draws under the

facility are probable and credit weaknesses exist. For

example, deterioration in the account party’s financial

condition could jeopardize performance under the letter of

credit and result in a draw by the beneficiary. If a draw

occurs, the offsetting loan to the account party may

become a collection problem, especially if it is unsecured.

Loan Commitments

A loan commitment is a written agreement, signed by the

borrower and bank, detailing the terms and conditions

under which the bank will fund a loan. The commitment

will specify a funding limit and have an expiration date.

For agreeing to make the accommodation, the bank may

require a fee and/or maintenance of a stipulated

compensating deposit balance from the customer. A

commitment can be irrevocable (like an SBLC facility)

and operate as a contractual obligation by the bank to lend

when requested by the customer. Generally, commitments

are conditioned on the customer maintaining a satisfactory

financial position and the absence of defaults in other

covenants. A bank may also enter into an agreement to

purchase loan commitments from another institution,

which should be reflected as off-balance sheet items, until

the sale is consummated. Loan commitments related to

mortgage loans that will be held for sale are discussed in

the Mortgage Banking Section below.

me types of commitments are expected to be drawn

upon, such as a revolving working capital line to fund

operating expenses or a term loan facility for equipment

purchases or developing a property. Other commitments

serve as backup facilities, such as for commercial paper,

whereby draws would not be anticipated unless the

customer is unable to retire or roll over the issue at

maturity.

Less detailed than a formal loan commitment, is a line of

credit, which expresses to the customer, usually by letter, a

OFF-BALANCE SHEET ACTIVITIES Section 3.8

Off-Balance Sheet Activities (6/19) 3.8-4 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

willingness by the bank to lend up to a certain amount over

a specified period. This type of facility is disclosed to the

customer and referred to as advised or confirmed lines, in

contrast to guidance lines, which are not made known to

the customer, but are merely used by the bank as lending

guidelines for internal control or operational purposes.

Many lines of credit are cancelable if the customer's

financial condition deteriorates, while others are simply

subject to cancellation at the bank’s option.

Disagreements can arise as to what constitutes a legally

binding commitment on the part of the bank. For example,

a credit arrangement could be referred to as a revocable

line of credit, but at the same time, it may be a legally

binding commitment to lend if consideration has been

given by the customer and the terms of the agreement

between the parties result in a contract. When appropriate,

examiners should consider the extent of the bank’s legal

obligation to fund commitments designated as revocable to

ensure that obligations are properly documented and

legally defensible should the bank need to cancel a loan

commitment.

Credit documentation often contains a material adverse

change (MAC) clause, which is intended to allow the bank

to terminate the commitment or line of credit arrangement

if the customer's financial condition deteriorates. The

extent to which a MAC clause is enforceable depends on

whether a legally binding relationship continues if specific

financial covenants are violated. Although the

enforceability of MAC clauses may be subject to some

uncertainty, such clauses may provide the bank with

leverage in negotiations with the customer over issues such

as requests for additional collateral or personal guarantees.

Whether a bank will fund a loan commitment or line of

credit cannot always be easily determined; therefore,

careful analysis is often necessary. A MAC clause may

allow the bank to decline funding to a borrower that

defaulted on a loan covenant. Some banks may decline

funding requests if any covenant is broken, whereas others

might be more accommodative and make advances unless

a borrower appears likely to file bankruptcy. The

procedures followed by the bank, in acceding to or

denying funding requests involving adverse conditions

commonly factor in a borrower’s financial condition,

credit history, and repayment prospects. These factors are

also important considerations in the examiner's overall

evaluation of credit risk.

Examiners should consider the type, volume, and

anticipated funding of loan commitments and lines of

credit when assessing a bank's funds-management program

and rating the liquidity position. Examiners should review

internal management reports estimating the amount of

commitments that require funding over various periods.

For further information, refer to the Liquidity and Funds

Management section of this Manual.

←

TRANSFERS OF FINANCIAL ASSETS

Mortgage Banking

Commitments to originate mortgage loans that will be held

for sale often include interest rate lock commitments. In

general, rate lock commitments are agreements to extend

credit to a borrower at a specified interest rate. The

agreements, which can involve fixed or floating rate

commitments, protect borrowers from rising interest rates

while loan applications are being processed.

Interest rate lock commitments on mortgage loans that will

be held for sale are derivatives and must be recorded at fair

value on the balance sheet as either an asset or liability.

The commitments are reported as over-the-counter written

options on schedule RC-L, Derivatives and Off-Balance

Sheet Items, along with its notional amount.

Banks often enter into an agreement with an investor to

sell mortgage loans that are originated under mandatory-

delivery or best-efforts contracts. Mandatory-delivery and

best-efforts contacts that meet the definition of a derivative

are reported on the balance sheet at fair value and on

schedule RC-L as forward loan sales commitments. In lieu

of entering into a best efforts or mandatory-delivery

contract, a bank may use the securitization market as a

facility for selling originated mortgage loans.

bank may not offset derivatives with negative fair values

(liabilities) against those with positive fair value (assets),

unless the criteria for netting under U.S. GAAP have been

satisfied. Further, a bank may not offset the fair value of

forward loan sales commitments against the fair value of

derivative loan commitments of mortgage loans held for

sale because the commitments typically have different

counterparties.

Commitments to originate mortgage loans that will be held

for investment purposes and commitments to originate

other types of loans require evaluation to determine

whether the commitments meet the criteria of a derivative.

Often, these commitments to lend will not meet the net

settlement requirement under ASC Topic 815 and would

not be considered derivatives. Unused portions of loan

commitments not considered derivatives are reported as

off-balance sheet items if the aggregate amount

individually exceeds 10 percent of the bank’s equity

capital.

OFF-BALANCE SHEET ACTIVITIES Section 3.8

RMS Manual of Examination Policies 3.8-5 Off-Balance Sheet Activities (6/19)

Federal Deposit Insurance Corporation

The accounting and reporting standards for derivative

activities are set forth in ASC Topic 815, Derivatives and

Hedging and in ASC Topic 948, Financial Services -

Mortgage Banking. ASC Topic 815 requires all

derivatives to be recognized on the balance sheet as either

assets or liabilities at their fair value. Additional

information is available in the Capital Markets Handbook,

the Call Report Glossary, and the instructions for RC-L,

Derivatives and Off-Balance Sheet Items.

Financial Assets Sold Without Recourse

Financial assets sold without recourse, where the bank has

surrendered control and meets the other conditions of a

sale under ASC Topic 860, are accounted for as loan sales.

In the case of loan participations, the transfer of a portion

of an entire financial asset must meet the definition of a

participating interest. If the transfer of a portion of a

financial asset qualifies as a participating interest, and the

other conditions for sale are met, the bank is required to

allocate the previous carrying amount of the loan between

the participating interest sold and the participating interest

it continues to hold based on relative fair values as of the

date of transfer. Further discussion of loan participations

is contained in the Loans section of this Manual.

If, as a result of a change in circumstances, a selling bank

regains control of a transferred financial asset that was

previously accounted for as a sale, the change should

generally be accounted for in the same manner as a

purchase of a transferred financial asset from the purchaser

in exchange for the liability assumed. If a transfer of the

financial asset does not meet the conditions for sale

treatment, the transferring bank and the acquiring

transferee shall account for the transfer as a secured

borrowing with pledge of collateral.

Financial Assets Sold With Recourse

Financial assets transferred with recourse may or may not

qualify for sales treatment under U.S. GAAP. In some

circumstances, recourse provisions could mean that the

transferred financial asset(s) have not been isolated beyond

the reach of the transferring bank or its consolidated

affiliates, i.e., the first criteria under ASC 860 for sales

treatment. For example, when an insured bank transfers

loan participation with recourse, the participation generally

will not be considered isolated from the selling bank in the

event of FDIC receivership. Section 360.6 of FDIC Rules

and Regulations limits the Corporation’s ability to reclaim

loan participations without recourse as defined in the

regulation, but does not limit the Corporation’s ability to

reclaim loan participations with recourse. Recourse

provisions in loan participations sold prior to January 1,

2002, do not necessarily preclude sale accounting for the

transfer. Refer to Manual Section 3.2 - Loans for

additional information.

If the financial asset transfer, e.g., a loan sale, qualifies as

a sale under ASC Topic 860, the bank shall remove the

transferred asset from the balance sheet, recognize and

initially measure the fair value of the servicing asset or

liability (if applicable) and any other asset obtained or

liability incurred, before recognizing the gain or loss on

the sale. Transfers of financial assets not meeting sales

treatment are accounted for as secured borrowings.

If an asset transfer that qualifies for sale treatment under

U.S. GAAP contains certain recourse provisions, the

transaction would be treated as an asset sale with recourse

for purposes of reporting risk-based capital information in

Schedules RC-R and RC-S within the Call Report. When

reviewing assets sold with recourse, examiners should

consider the recourse attributes when calculating risk-

based capital. For further information, refer to the Call

Report Glossary under Transfers of Financial Assets, ASC

Topic 860, and Part 324 of the FDIC Rules and

Regulations.

Recourse and Direct Credit Substitutes

A recourse obligation or direct credit substitute may arise

when a bank transfers assets in a sale and retains an

obligation to repurchase the assets or absorb losses. The

repurchase or absorption of losses may be due to a default

of principal or interest or any other deficiency in the

performance of the underlying obligor. Recourse may also

exist implicitly where a bank provides credit enhancements

beyond any contractual obligation to support assets it sold.

When an examiner encounters recourse arrangements or

direct credit substitutes (commonly found in securitization

and mortgage banking operations), they should refer to the

Call Report instructions, Part 324 of the FDIC Rules and

Regulations, and ASC Topics 815 and 860.

←

OFF-BALANCE SHEET CONTINGENT

LIABILITIES

Bankers Acceptances

The following discussion refers to the roles of accepting

and endorsing banks in bankers acceptances. It does not

apply to banks purchasing other banks' acceptances for

investment purposes, which is described in the Other

Assets and Liabilities section of this Manual. Bankers

acceptances may represent either a direct or a contingent

liability of the bank. If the bank creates the acceptance, it

constitutes a direct liability that must be paid on a

OFF-BALANCE SHEET ACTIVITIES Section 3.8

Off-Balance Sheet Activities (6/19) 3.8-6 RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

specified future date. If a bank participates in funding an

acceptance created by another bank, the liability resulting

from such endorsement is only contingent in nature. In

analyzing the degree of risk associated with these

contingent liabilities, the financial strength and repayment

ability of the accepting bank should be considered.

Further discussion of bankers acceptances is contained in

the International Banking section of this Manual under the

heading Forms of International Lending and in the

Glossary of the Instructions for the Call Report.

Revolving Underwriting Facilities

A revolving underwriting facility (RUF) (also referred to

as a note issuance facility) is a commitment by a group of

banks to purchase, at a fixed spread over some interest rate

index, the short-term notes that the issuer/borrower is

unable to sell in the Euromarkets, at or below the

predetermined rate. In effect, the borrower anticipates

selling the notes as funds are needed at money market

rates, but if unable to do so, has the assurance that credit

will be available under the RUF at a maximum spread over

the stipulated index. A lead bank generally arranges the

facility and receives a one-time fee, and the RUF banks

receive an annual commitment or underwriting fee. When

the borrower elects to draw down funds, placement agents

arrange for a sale of the notes and normally receive

compensation based on the amount of notes placed. The

notes usually have a maturity range of 90 days to one year

and the purchasers bear the risk of any default on the part

of the borrower. There are also standby RUFs, which are

commitments under which Euronotes are not expected to

be sold in the normal course of the borrower's business.

An inability to sell notes in the Euromarkets could result

from financial deterioration of the borrower, or from

volatile, short-term market conditions, which precipitate a

call by the borrower on the participating banks for funding

under the RUF arrangement. The evaluation of RUFs by

the examiner should follow the same procedures used for

reviewing loan commitments. An adverse classification

should be accorded if it is determined that a loan of

inferior quality will be funded under a RUF.

Standby LOC Issued By Another Depository

Institution

Standby letters of credit issued by another depository

institution (such as a correspondent bank), a Federal Home

Loan Bank (FHLB), or another entity on behalf of a bank

are potential future obligations for the bank that are

reported as other off-balance sheet liabilities. Often, an

FHLB will offer SBLC products to secure uninsured

public deposits (i.e., deposit balances from public entities

exceeding FDIC insurance limits, which may require

additional protection due to state laws). Banks may

choose this option as an alternative to pledging liquid

assets such as U.S. Treasury securities. However, this

does not mean the bank is free of asset encumbrance. As

part of the SBLC agreement, the FHLB agreements may

require collateral, but from a wider variety of assets, such

as loans or other types of securities.

It is important to assess the implications for pledging

requirements and contingent funding availability when a

bank uses SBLCs to meet public deposit collateral

requirements. The Call Report can serve as an initial

source to gauge an institution’s involvement in this

activity. Schedule RC-L, item 9.c requires banks to report

SBLCs if the total amount is greater than 25 percent of

total equity capital (reported in Schedule RC, item 27.a).

←

ADVERSELY CLASSIFIED CONTINGENT

LIABILITIES

Category I contingent liabilities are defined as liabilities

that will give rise to a corresponding increase in bank

assets if the contingencies convert into actual liabilities.

Such contingencies should be evaluated for credit risk and

if appropriate, listed for Special Mention or adverse

classification. This examination treatment does not apply

to Category II contingent liabilities where there will be no

equivalent increase in assets if a contingency becomes a

direct liability. Examination treatment of Category II

contingencies is covered under Contingent Liabilities in

the Capital section of this Manual.

The classification of Category I contingencies is dependent

upon two factors: the likelihood of the liability becoming

direct and the credit risk of the potential acquired asset.

Examiners should refer to the Report of Examination

Instructions and the Bank of Anytown contained in this

Manual for Report of Examination treatment when

considering to list contingent liabilities as special mention

or to assign adverse classifications.

Adverse classification and Special Mention definitions for

direct loans are set forth in the Loans section of this

Manual. The following adverse classification and Special

Mention criteria should be viewed as a supplement to those

definitions when evaluating contingent liability credit risk.

Special Mention – The chance of the contingency

becoming an actual liability is at least reasonably possible,

and the potentially acquired assets are considered worthy

of Special Mention. An example would be the undrawn

portion of a poorly supervised accounts receivable line

where the drawn portion is listed for Special Mention.

OFF-BALANCE SHEET ACTIVITIES Section 3.8

RMS Manual of Examination Policies 3.8-7 Off-Balance Sheet Activities (6/19)

Federal Deposit Insurance Corporation

Substandard – The chance of the contingency becoming

an actual liability is at least reasonably possible, and the

potentially acquired assets are considered no better than

Substandard quality. Undisbursed loan funds in a

speculative real estate venture in which the disbursed

portion is classified Substandard and the probability of the

bank acquiring the underlying property is high, would be

an example of a Substandard contingency.

Doubtful – The chance of the contingency becoming an

actual liability is probable, and the potentially acquired

assets are considered of Doubtful quality. Undisbursed

loan funds on an incomplete construction project wherein

cost overruns or diversion of funds will likely result in the

bank sustaining significant loss from disposing the

underlying property could be an example of a Doubtful

contingency.

Loss – The chance of the contingency becoming an actual

liability is probable, and the potentially acquired assets are

not considered of bankable quality. A letter of credit on

which the bank will probably be forced to honor draws that

are considered uncollectible is an example of a Loss

contingency. A Loss classification normally indicates that

a balance sheet liability (specific reserve) should be

established to cover the estimated loss. For further

information as to when a contingency should be reflected

as a direct liability on the balance sheet, refer to ASC

Subtopic 450-20, Contingencies, Loss Contingencies.