moving assets off the balance sheet

[Ened]

What are the arguments for a firm to move assets off the balance sheet? And what are the advantages and disadvantages?

 

[David Harper CFA FRM]

Hi Ened,

Big topic. This would be a great AIM, IMO, this should be the first AIM in securitization! There can be many motives, I will just start with:

Regulatory advantage: under Basel I, a bank could sometimes do better by moving an asset off balance sheet where the treatment could be more favorable (some have argued that Basel I encouraged the creation of derivative instruments specifically for this purpose). There is should be (will be) a Basel AIM about how Basel I encourages(ed) regulatory arbitrage; refers to incentive for banks to take on risky loans. This is part of a broader "capital arbitrage" that included the incentive to move stuff off balance sheet

Accounting advantage: a bank (or firm) can generally increase its ROA, ROE, ROC by shrinking its balance sheet. This is supposed to be "window dressing" to a professional analyst; in the CFA, the whole point of fundamental analysis is to un-ravel the accounting and translate into economics (e.g., put stuff back on the balance sheet). The classic example here is operating versus capital lease. But, obviously, banks don't trust everybody does this, just as firms care about reported EPS.

Healthy economic advantages: good old-fashioned securitization is/was to monetize assets and transfer risk. As the "next best thing" to selling assets, removing from the balance sheet signifies (correctly) that assets have been transferred, somebody else has the credit risk and profits (gain on sale) can be booked.

Disadvantages (just my top picks, someone else may have better):

1. Less transparency; e.g., if a bank has counterparty risk in an off-balance-sheet swap, that makes understanding their true capital structure more difficult.

2. Could distort true size & economic capital structure. And so, could distort analytics like cost of capital. And, recall the KMV Merton model we study for credit risk? This determined EDF in part by capital structure (ST debt + 1/2 LT debt). The true default threshold may be distorted by off balance sheet

I hope that helps for a starter list...David

 

[Ened]

Thanks. Great answer.
This helps me putting things in perspective.

 

[David Harper CFA FRM]

good deal, Ened.

catching up on my reading, caught this good summary:
http://www.ft.com/cms/s/0/af104c54-4706-11dd-876a-0000779fd2ac.html

add to advantage: tailored investments (tranches) to investor
add two *huge,* voguish disadvantages: 1. more distance (layers) between bank and asset, 2. increased systemic risk

David

 

[Dettos]

Hi Ened,

Big topic. This would be a great AIM, IMO, this should be the first AIM in securitization! There can be many motives, I will just start with:

Regulatory advantage: under Basel I, a bank could sometimes do better by moving an asset off balance sheet where the treatment could be more favorable (some have argued that Basel I encouraged the creation of derivative instruments specifically for this purpose). There is should be (will be) a Basel AIM about how Basel I encourages(ed) regulatory arbitrage; refers to incentive for banks to take on risky loans. This is part of a broader "capital arbitrage" that included the incentive to move stuff off balance sheet

Accounting advantage: a bank (or firm) can generally increase its ROA, ROE, ROC by shrinking its balance sheet. This is supposed to be "window dressing" to a professional analyst; in the CFA, the whole point of fundamental analysis is to un-ravel the accounting and translate into economics (e.g., put stuff back on the balance sheet). The classic example here is operating versus capital lease. But, obviously, banks don't trust everybody does this, just as firms care about reported EPS.
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Healthy economic advantages: good old-fashioned securitization is/was to monetize assets and transfer risk. As the "next best thing" to selling assets, removing from the balance sheet signifies (correctly) that assets have been transferred, somebody else has the credit risk and profits (gain on sale) can be booked.

Disadvantages (just my top picks, someone else may have better):

1. Less transparency; e.g., if a bank has counterparty risk in an off-balance-sheet swap, that makes understanding their true capital structure more difficult.

2. Could distort true size & economic capital structure. And so, could distort analytics like cost of capital. And, recall the KMV Merton model we study for credit risk? This determined EDF in part by capital structure (ST debt + 1/2 LT debt). The true default threshold may be distorted by off balance sheet


I hope that helps for a starter list...David

thanks!