The market's evaluation of off-balance sheet banking risk: a methodological reexamination

The empirical literature, to date, has ignored the impact of Off-balance sheet (OBS) banking activities on the default-risk premia borne by bank subordinated debtholders. This paper examines the "market discipline" of OBS activities by employing a contingent claims pricing model to the default-risk premia on subordinated debt. The standard approach to determine if market prices of subordinated debt reflect the risk of default is to regress the yield spread against accounting measures of bank risk. This approach is inadequate because yield spreads are neither linear nor monotonic functions of bank risk. Moreover, this approach fails to account for the fact that banks are regulated. Observed yields on subordinated bank debt over equivalent maturity treasuries are used to compute implied asset variances. OBS banking activities appear to reduce both linear risk-premia and implied asset variances. These results suggest that bank regulators are overly concerned with the risk exposure of OBS activities. The risk-based capital requirement of OBS banking activities may be inappropriate.