Obligations that are contingent liabilities of a bank, and thus do not appear on its balance sheet. In general, off-balance sheet items include the following: direct credit substitutes in which a bank substitutes its own credit for a third party, including standby letters of credit; irrevocable letters of credit that guarantee repayment of commercial paper or tax-exempt securities; risk participations in bankers' acceptances; sale and repurchase agreements; and asset sales with recourse against the seller; interest rate swaps; interest rate options and currency options, and so on.
Under the Risk-Based Capital guidelines approved by banking regulators for bank holding companies and state member banks, banks are required to hold a portion of equity capital in reserve to meet contingent obligations in off-balance sheet items. This is based on a risk-weighted scale that requires holding more capital in reserve for certain assets, up to 100% of the prevailing capital requirement for certain assets, and as little as 0% for liquid, easily marketable assets. Risk weights are determined by multiplying each off-balance sheet item by a conversion factor to yield a credit equivalent amount. Thus, if the required capital-to-asset ratio is 8%, off-balance sheet items given a 100% risk weight would require an 8% capital backing; a 50% risk weighting requires a 4% capital support. Anything qualifying for placement in more than one category is assigned the lowest applicable risk rating.
The risk weights for off-balance sheet items are as follows:
100% risk weight: standby letters of credit, risk participations, asset sales with recourse, risk participations in bankers' acceptances.
50% risk weight: unused portions of loan or lease commitments with original maturities of more than one year; Revolving Underwriting Agreements, Note Issuance Facilities.
20% risk weight: short-term commercial letters of credit, and documentary letters of credit collateralized by the underlying shipments.
