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CMA Final · Risk Management in Banking and Insurance · Operational Risk and Off-Balance Sheet Risk

Which statement best describes why a bank's letter of credit and guarantee commitments are called off-balance sheet risk?

These instruments are contingent liabilities that stay off the balance sheet until a trigger event occurs. If the customer defaults, the bank must honour payment and the exposure becomes funded, so the bank carries credit risk and must hold capital against it.

  1. AThey create contingent liabilities that may become actual funded exposures if the event occursCorrect
  2. BThey are always recorded as deposits
  3. CThey have no possibility of loss to the bank
  4. DThey are treated only as market risk instruments with no credit element

Explanation

Letters of credit and guarantees are not funded at inception, so they do not appear as assets or liabilities in the balance sheet, but they are contingent liabilities. If the customer defaults, the bank must pay and the exposure becomes funded, hence the credit risk and capital requirement.

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