OFF-BALANCE SHEET ACTIVITIES Section 3.

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

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OFF-BALANCE SHEET ACTIVITIES Section 3.8

INTRODUCTION When analyzing off-balance sheet lending activities,

examiners should evaluate the probability that lines will be
Off-balance sheet activities include items such as loan funded and, if applicable, whether loss allowances
commitments, letters of credit, and revolving underwriting adequately reflect off-balance sheet credit risks. Such
facilities. Institutions are required to report off-balance allowances should not be included as part of the general
sheet items in conformance with Call Report Instructions. allowance for loan and lease losses (ALLL). Credit
The use of off-balance sheet activities may improve exposures on financial instruments with off-balance sheet
earnings ratios because earnings generated from the credit risk should be recorded separate from the ALLL
activities are included in the income numerator, while the related to a recognized financial instrument (i.e., an on-
balance of total assets included in the denominator remains balance sheet financial asset). Allowances for off-balance
unchanged. sheet credit exposures are reported in Call Report Schedule
RC-G - Other Liabilities.
Examiners should review the risks and controls associated
with off-balance sheet activities during examinations. Examiners should also consider standby letters of credit
Reviews should consider the adequacy of items such as: when determining legal limitations on loans to one
borrower and compliance with Section 337.2(b) of the
• Policies, practices, and internal controls; FDIC Rules and Regulations.
• Conformance with applicable laws and internal bank
guidelines; Letters of Credit
• Credit quality and collectability of off-balance-sheet
credit items; and A letter of credit (LOC) is a document issued by a bank on
• Board oversight and audit activities. 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)
OFF-BALANCE SHEET LENDING on the bank’s part to pay drafts drawn in accordance with
ACTIVITIES the document’s terms. There are four basic types of letters
of credit: travelers, sold for cash, commercial, and standby.
When reviewing off-balance sheet lending activities,
examiners should apply the same general examination Travelers – A travelers letter of credit is addressed by the
techniques they use when evaluating a direct loan bank to its correspondents authorizing drafts by the person
portfolio. For example, examiners should consider the named in accordance with specified terms. These letters
adequacy of internal controls and board-approved policies are generally sold for cash.
at banks with a material level of off-balance sheet lending
activities. Comprehensive policies generally address Sold for Cash – When a letter of credit is sold for cash,
issues such as underwriting standards, documentation and the bank receives funds from the account party at the time
file maintenance requirements, collection and review of issuance. This letter is not reported as a contingent
procedures, officer lending limits and customer borrowing liability, but rather as a demand deposit.
limits, board and loan committee approval requirements,
and board reporting requirements. Generally, overall Commercial – A commercial letter of credit is issued to
limits on contingent liabilities and specific sub-limits on facilitate trade or commerce. Generally, drafts are drawn
various types of off-balance sheet lending activities, either upon when the underlying transaction is consummated as
as a dollar amount or as a relative percentage (such as a intended. Commercial letters of credit not sold for cash
percent of total assets or capital), are also often addressed. represent contingent liabilities. Refer to the International
Banking section of this Manual for further details on
When evaluating individual credit lines, examiners should commercial letters of credit.
review all of a customer's borrowing arrangements with
the bank (e.g., direct loans, letters of credit, and loan Standby – A standby letter of credit (SBLC) is an
commitments). Other factors analyzed during direct loan irrevocable commitment on the part of the issuing bank to
reviews, such as collateral protection and the borrower’s make payment to a designated beneficiary. Payments to a
financial condition, repayment history, and beneficiary are guaranteed in exchange for an ongoing,
ability/willingness to pay are also applicable when periodic fee throughout the life of the letter. An SBLC can
reviewing contingent liabilities such as letters of credit and be either financial-oriented, where the account party is to
loan commitments. 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

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OFF-BALANCE SHEET ACTIVITIES Section 3.8

improve the credit rating of a beneficiary, to assure

performance under construction contracts, and to ensure Section 337.2(d) of the FDIC Rules and Regulations
the beneficiary satisfies financial obligations payable to requires banks to maintain adequate controls and
major suppliers. subsidiary records of SBLCs, comparable to records
maintained on direct loans, so that a bank's total liability
ASC Topic 460, Guarantees, clarifies that a guarantor is may be determined at all times. Banks are also required to
required to recognize, at the inception of a guarantee, a reflect all SBLCs on published financial statements.
liability for the fair value of the obligation undertaken in Consistent with Section 337.2(d) credit files should reflect
issuing the guarantee. ASC Topic 460 applies to standby the current status of SBLCs, and adequate reports
letters of credit, both financial and performance. regarding the types and volume of SBLCs should be
Commercial letters of credit and other loan commitments, maintained. These reports enable management and the
commonly thought of as funding guarantees, are not board to monitor credit risks and identify potential
included in the scope of ASC Topic 460 because those concentrations so that appropriate action can be taken, if
instruments do not guarantee payment of a money needed, to reduce undue exposure.
obligation and do not provide for payment in the event of
default by the account party. Examiners should assess the need to adversely classify or
designate as Special Mention an SBLC if draws under the
While no particular form is required, SBLC documents facility are probable and credit weaknesses exist. For
generally contain certain descriptive information. The first example, deterioration in the account party’s financial
item generally includes a separate binding agreement condition could jeopardize performance under the letter of
wherein the account party agrees to reimburse the bank for credit and result in a draw by the beneficiary. If a draw
any payments made under the SBLC. The actual letter is occurs, the offsetting loan to the account party may
often labeled as a standby letter of credit, specifies a become a collection problem, especially if it is unsecured.
stipulated amount, covers a specific period, and details
relevant information that must be presented to the bank Loan Commitments
before any draws will be honored due to the account
party's failure to perform. Most SBLCs are carefully A loan commitment is a written agreement, signed by the
worded so that the bank is not involved in making any borrower and bank, detailing the terms and conditions
determinations of fact or law at issue between the account under which the bank will fund a loan. The commitment
party and the beneficiary. will specify a funding limit and have an expiration date.
For agreeing to make the accommodation, the bank may
The primary risks relative to SBLCs are credit risk (the require a fee and/or maintenance of a stipulated
possibility of default on the part of the account party), and compensating deposit balance from the customer. A
funding risk (the potential inability of the bank to fund a commitment can be irrevocable (like an SBLC facility)
large draw from normal sources). An SBLC is a potential and operate as a contractual obligation by the bank to lend
extension of credit and should be evaluated in a manner when requested by the customer. Generally, commitments
similar to direct loans. The credit risk could be significant are conditioned on the customer maintaining a satisfactory
under an SBLC given its irrevocable nature, especially if financial position and the absence of defaults in other
the SBLC is written for an extended period. Generally, a covenants. A bank may also enter into an agreement to
bank can rescind a direct loan commitment to a customer if purchase loan commitments from another institution,
the customer’s financial condition deteriorated and the which should be reflected as off-balance sheet items, until
loan commitment contained an adverse-change clause. the sale is consummated. Loan commitments related to
However, such would not be applicable with an SBLC mortgage loans that will be held for sale are discussed in
since it is an irrevocable agreement between the bank and the Mortgage Banking Section below.
the beneficiary.
Some types of commitments are expected to be drawn
An SBLC can be participated or syndicated. Unlike loans, upon, such as a revolving working capital line to fund
however, the sale of SBLC participations does not operating expenses or a term loan facility for equipment
diminish the total contingent liability of the issuing bank. purchases or developing a property. Other commitments
The name of the issuing bank is on the actual letter of serve as backup facilities, such as for commercial paper,
credit, and the bank must therefore honor all drafts whereby draws would not be anticipated unless the
whether or not the participants are willing or able to customer is unable to retire or roll over the issue at
disburse their pro rata share. Syndications, on the other maturity.
hand, represent legal apportionments of liability. If one
bank fails to fulfill its obligation under the SBLC, the Less detailed than a formal loan commitment, is a line of
remaining banks are not liable for that bank's share. credit, which expresses to the customer, usually by letter, a

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OFF-BALANCE SHEET ACTIVITIES Section 3.8

willingness by the bank to lend up to a certain amount over For further information, refer to the Liquidity and Funds
a specified period. This type of facility is disclosed to the Management section of this Manual.
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 TRANSFERS OF FINANCIAL ASSETS
guidelines for internal control or operational purposes.
Many lines of credit are cancelable if the customer's
Mortgage Banking
financial condition deteriorates, while others are simply
subject to cancellation at the bank’s option.
Commitments to originate mortgage loans that will be held
for sale often include interest rate lock commitments. In
Disagreements can arise as to what constitutes a legally
general, rate lock commitments are agreements to extend
binding commitment on the part of the bank. For example,
credit to a borrower at a specified interest rate. The
a credit arrangement could be referred to as a revocable
agreements, which can involve fixed or floating rate
line of credit, but at the same time, it may be a legally
commitments, protect borrowers from rising interest rates
binding commitment to lend if consideration has been
while loan applications are being processed.
given by the customer and the terms of the agreement
between the parties result in a contract. When appropriate,
Interest rate lock commitments on mortgage loans that will
examiners should consider the extent of the bank’s legal
be held for sale are derivatives and must be recorded at fair
obligation to fund commitments designated as revocable to
value on the balance sheet as either an asset or liability.
ensure that obligations are properly documented and
The commitments are reported as over-the-counter written
legally defensible should the bank need to cancel a loan
options on schedule RC-L, Derivatives and Off-Balance
commitment.
Sheet Items, along with its notional amount.
Credit documentation often contains a material adverse
Banks often enter into an agreement with an investor to
change (MAC) clause, which is intended to allow the bank
sell mortgage loans that are originated under mandatory-
to terminate the commitment or line of credit arrangement
delivery or best-efforts contracts. Mandatory-delivery and
if the customer's financial condition deteriorates. The
best-efforts contacts that meet the definition of a derivative
extent to which a MAC clause is enforceable depends on
are reported on the balance sheet at fair value and on
whether a legally binding relationship continues if specific
schedule RC-L as forward loan sales commitments. In lieu
financial covenants are violated. Although the
of entering into a best efforts or mandatory-delivery
enforceability of MAC clauses may be subject to some
contract, a bank may use the securitization market as a
uncertainty, such clauses may provide the bank with
facility for selling originated mortgage loans.
leverage in negotiations with the customer over issues such
as requests for additional collateral or personal guarantees.
A bank may not offset derivatives with negative fair values
(liabilities) against those with positive fair value (assets),
Whether a bank will fund a loan commitment or line of
unless the criteria for netting under U.S. GAAP have been
credit cannot always be easily determined; therefore,
satisfied. Further, a bank may not offset the fair value of
careful analysis is often necessary. A MAC clause may
forward loan sales commitments against the fair value of
allow the bank to decline funding to a borrower that
derivative loan commitments of mortgage loans held for
defaulted on a loan covenant. Some banks may decline
sale because the commitments typically have different
funding requests if any covenant is broken, whereas others
counterparties.
might be more accommodative and make advances unless
a borrower appears likely to file bankruptcy. The
Commitments to originate mortgage loans that will be held
procedures followed by the bank, in acceding to or
for investment purposes and commitments to originate
denying funding requests involving adverse conditions
other types of loans require evaluation to determine
commonly factor in a borrower’s financial condition,
whether the commitments meet the criteria of a derivative.
credit history, and repayment prospects. These factors are
Often, these commitments to lend will not meet the net
also important considerations in the examiner's overall
settlement requirement under ASC Topic 815 and would
evaluation of credit risk.
not be considered derivatives. Unused portions of loan
commitments not considered derivatives are reported as
Examiners should consider the type, volume, and
off-balance sheet items if the aggregate amount
anticipated funding of loan commitments and lines of
individually exceeds 10 percent of the bank’s equity
credit when assessing a bank's funds-management program
capital.
and rating the liquidity position. Examiners should review
internal management reports estimating the amount of
commitments that require funding over various periods.

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The accounting and reporting standards for derivative transfer. Refer to Manual Section 3.2 - Loans for
activities are set forth in ASC Topic 815, Derivatives and additional information.
Hedging and in ASC Topic 948, Financial Services -
Mortgage Banking. ASC Topic 815 requires all If the financial asset transfer, e.g., a loan sale, qualifies as
derivatives to be recognized on the balance sheet as either a sale under ASC Topic 860, the bank shall remove the
assets or liabilities at their fair value. Additional transferred asset from the balance sheet, recognize and
information is available in the Capital Markets Handbook, initially measure the fair value of the servicing asset or
the Call Report Glossary, and the instructions for RC-L, liability (if applicable) and any other asset obtained or
Derivatives and Off-Balance Sheet Items. liability incurred, before recognizing the gain or loss on
the sale. Transfers of financial assets not meeting sales
Financial Assets Sold Without Recourse treatment are accounted for as secured borrowings.

Financial assets sold without recourse, where the bank has If an asset transfer that qualifies for sale treatment under
surrendered control and meets the other conditions of a U.S. GAAP contains certain recourse provisions, the
sale under ASC Topic 860, are accounted for as loan sales. transaction would be treated as an asset sale with recourse
In the case of loan participations, the transfer of a portion for purposes of reporting risk-based capital information in
of an entire financial asset must meet the definition of a Schedules RC-R and RC-S within the Call Report. When
participating interest. If the transfer of a portion of a reviewing assets sold with recourse, examiners should
financial asset qualifies as a participating interest, and the consider the recourse attributes when calculating risk-
other conditions for sale are met, the bank is required to based capital. For further information, refer to the Call
allocate the previous carrying amount of the loan between Report Glossary under Transfers of Financial Assets, ASC
the participating interest sold and the participating interest Topic 860, and Part 324 of the FDIC Rules and
it continues to hold based on relative fair values as of the Regulations.
date of transfer. Further discussion of loan participations
is contained in the Loans section of this Manual. Recourse and Direct Credit Substitutes
If, as a result of a change in circumstances, a selling bank A recourse obligation or direct credit substitute may arise
regains control of a transferred financial asset that was when a bank transfers assets in a sale and retains an
previously accounted for as a sale, the change should obligation to repurchase the assets or absorb losses. The
generally be accounted for in the same manner as a repurchase or absorption of losses may be due to a default
purchase of a transferred financial asset from the purchaser of principal or interest or any other deficiency in the
in exchange for the liability assumed. If a transfer of the performance of the underlying obligor. Recourse may also
financial asset does not meet the conditions for sale exist implicitly where a bank provides credit enhancements
treatment, the transferring bank and the acquiring beyond any contractual obligation to support assets it sold.
transferee shall account for the transfer as a secured
borrowing with pledge of collateral. When an examiner encounters recourse arrangements or
direct credit substitutes (commonly found in securitization
Financial Assets Sold With Recourse and mortgage banking operations), they should refer to the
Call Report instructions, Part 324 of the FDIC Rules and
Financial assets transferred with recourse may or may not Regulations, and ASC Topics 815 and 860.
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 OFF-BALANCE SHEET CONTINGENT
the reach of the transferring bank or its consolidated LIABILITIES
affiliates, i.e., the first criteria under ASC 860 for sales
treatment. For example, when an insured bank transfers
Bankers Acceptances
loan participation with recourse, the participation generally
will not be considered isolated from the selling bank in the
The following discussion refers to the roles of accepting
event of FDIC receivership. Section 360.6 of FDIC Rules
and endorsing banks in bankers acceptances. It does not
and Regulations limits the Corporation’s ability to reclaim
apply to banks purchasing other banks' acceptances for
loan participations without recourse as defined in the
investment purposes, which is described in the Other
regulation, but does not limit the Corporation’s ability to
Assets and Liabilities section of this Manual. Bankers
reclaim loan participations with recourse. Recourse
acceptances may represent either a direct or a contingent
provisions in loan participations sold prior to January 1,
liability of the bank. If the bank creates the acceptance, it
2002, do not necessarily preclude sale accounting for the
constitutes a direct liability that must be paid on a

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OFF-BALANCE SHEET ACTIVITIES Section 3.8

specified future date. If a bank participates in funding an additional protection due to state laws). Banks may
acceptance created by another bank, the liability resulting choose this option as an alternative to pledging liquid
from such endorsement is only contingent in nature. In assets such as U.S. Treasury securities. However, this
analyzing the degree of risk associated with these does not mean the bank is free of asset encumbrance. As
contingent liabilities, the financial strength and repayment part of the SBLC agreement, the FHLB agreements may
ability of the accepting bank should be considered. require collateral, but from a wider variety of assets, such
Further discussion of bankers acceptances is contained in as loans or other types of securities.
the International Banking section of this Manual under the
heading Forms of International Lending and in the It is important to assess the implications for pledging
Glossary of the Instructions for the Call Report. requirements and contingent funding availability when a
bank uses SBLCs to meet public deposit collateral
Revolving Underwriting Facilities requirements. The Call Report can serve as an initial
source to gauge an institution’s involvement in this
A revolving underwriting facility (RUF) (also referred to activity. Schedule RC-L, item 9.c requires banks to report
as a note issuance facility) is a commitment by a group of SBLCs if the total amount is greater than 25 percent of
banks to purchase, at a fixed spread over some interest rate total equity capital (reported in Schedule RC, item 27.a).
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 ADVERSELY CLASSIFIED CONTINGENT
selling the notes as funds are needed at money market LIABILITIES
rates, but if unable to do so, has the assurance that credit
will be available under the RUF at a maximum spread over Category I contingent liabilities are defined as liabilities
the stipulated index. A lead bank generally arranges the that will give rise to a corresponding increase in bank
facility and receives a one-time fee, and the RUF banks assets if the contingencies convert into actual liabilities.
receive an annual commitment or underwriting fee. When Such contingencies should be evaluated for credit risk and
the borrower elects to draw down funds, placement agents if appropriate, listed for Special Mention or adverse
arrange for a sale of the notes and normally receive classification. This examination treatment does not apply
compensation based on the amount of notes placed. The to Category II contingent liabilities where there will be no
notes usually have a maturity range of 90 days to one year equivalent increase in assets if a contingency becomes a
and the purchasers bear the risk of any default on the part direct liability. Examination treatment of Category II
of the borrower. There are also standby RUFs, which are contingencies is covered under Contingent Liabilities in
commitments under which Euronotes are not expected to the Capital section of this Manual.
be sold in the normal course of the borrower's business.
The classification of Category I contingencies is dependent
An inability to sell notes in the Euromarkets could result upon two factors: the likelihood of the liability becoming
from financial deterioration of the borrower, or from direct and the credit risk of the potential acquired asset.
volatile, short-term market conditions, which precipitate a Examiners should refer to the Report of Examination
call by the borrower on the participating banks for funding Instructions and the Bank of Anytown contained in this
under the RUF arrangement. The evaluation of RUFs by Manual for Report of Examination treatment when
the examiner should follow the same procedures used for considering to list contingent liabilities as special mention
reviewing loan commitments. An adverse classification or to assign adverse classifications.
should be accorded if it is determined that a loan of
inferior quality will be funded under a RUF. Adverse classification and Special Mention definitions for
direct loans are set forth in the Loans section of this
Standby LOC Issued By Another Depository Manual. The following adverse classification and Special
Institution Mention criteria should be viewed as a supplement to those
definitions when evaluating contingent liability credit risk.
Standby letters of credit issued by another depository
institution (such as a correspondent bank), a Federal Home Special Mention – The chance of the contingency
Loan Bank (FHLB), or another entity on behalf of a bank becoming an actual liability is at least reasonably possible,
are potential future obligations for the bank that are and the potentially acquired assets are considered worthy
reported as other off-balance sheet liabilities. Often, an of Special Mention. An example would be the undrawn
FHLB will offer SBLC products to secure uninsured portion of a poorly supervised accounts receivable line
public deposits (i.e., deposit balances from public entities where the drawn portion is listed for Special Mention.
exceeding FDIC insurance limits, which may require

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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.

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