Which of the following regarding loan commitments is false? a. Loan commitments

Question

Which of the following regarding loan commitments is false?

a. Loan commitments are an off balance sheet activity, however it gets recorded on balance sheet when a business draws down on it.

b. A large amount of loan commitments causes high liquidity risk for banks because during economic downturns businesses all require more cash.

c. When a business draws down on a loan commitment, this is reflected on the liabilities side of the balance sheet of banks. On the asset side, cash decreases.

d. During the recent financial crisis, banks that had a lot of loan commitments had high liquidity risk because they didn’t have enough cash.

e. All of the above are true.

Explanation / Answer

The answer is (C).

When a business draws down on a loan commitment, this is reflected on the liabilities side of the balance sheet of banks. On the asset side, cash decreases. This is a false statement.

When a busines draws down on a loan commitment, it is actually utlizing the limits provided to it by the financier. This means the liabilities will increase as it draws down the facility and the contra accounting is the cash level increasing in the business as the drawdown occurs ie assets increases. For a bank, the undrawn amount will receive no interest and hence a worthless proposition as long as the company does not utilize the facility.

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