A methodological investigation of risk exposure of bank off-balance sheet loan commitment activities

This study provides further empirical evidence of capital market reactions to the growth and riskiness of bank off-balance sheet loan commitment activities. Previous studies have ignored the impact of regulation on the measurement of bank risk. In this research Ronn-Verma (1986) and Gorton-Santomero (1990) option pricing models are employed to calculate implied asset risk from bank equity and subordinated debt. This approach incorporates the nonlinearity of contingent claims valuation models, deposit insurance and regulatory closure rules. This research reports strong evidence that loan commitments reduce bank risk. In addition, decreases in equity risk, subordinated debt default risk and implied asset risk resulting from increases in loan commitments activities implies that loan commitments may contribute to the overall diversification of bank portfolio risk. It, therefore, may be inappropriate to include loan commitments in a risk-based capital calculation.