One of the most striking trends for many modern FIs has been the growth in their off-balance-sheet activities and thus their off-balance-sheet risk. Explain what is meant by off-balance-sheet activities and the risk associated with it using an example.

See the explanation below.

Explanation:

Off-balance sheet (OBS) activities to a situation whereby financial institutions (FIs) or any other companies do not some assets or liabilities in their balance sheet.

These assets and liabilities are still those of the company despite that they do not appear on the balance sheet of the company. However, off-balance sheet assets do not typically to the company and neither are the off-balance sheet liabilities the company's direct obligation.

The risk with off-balance sheet activities is that items related to them are not easy to single out and trace within the financial statement of a company as they usually included in the notes to the accounts. This usually prevents investors from knowing the financial exposure of the company.

An example of off-balance sheet items are collateralized debt obligations (CDO) which have the potential of turning to toxic assets. This is because they can instantly turn illiquid before the real financial exposure of the company is detected by investors who have already invested on the company.

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