The off-balance sheet banking risk of large U.S. commercial banks

Off-Balance Sheet (OBS) activities of large U.S. commercial banks have been growing rapidly in recent years. These activities represented 58% of total bank assets in 1984 and grew to 176% of total bank assets in 1988. Bank regulators are concerned that OBS activities increase bank risk, and proposed that some OBS activities be included in the calculation of a risk-based capital requirement. This paper investigates the impact of OBS activities on market measures of risk. Specifically, this paper examines the risk-reducing diversification and risk-increasing effects of OBS activities by employing implied asset variances, in addition to, equity and systematic risks as proxies for market measures of bank risk. This research contends that asset variance is a better measure of risk for regulated banking industry. A Ronn-Verma (JF, 1986) option pricing methodology is employed to calculate implied asset variances. Systematic risk, equity risk and implied asset risk are regressed over various measures of OBS items and on balance measures of risk in a Pooled Cross-section and Time-series sample. The results indicate that OBS activities, in general, reduce total risk, but do not affect systematic risk. The explanatory powers of the models are improved significantly when implied asset variances, instead of equity variances, are used to proxy for total risk. Because regulators are concerned with total risk and probability of bank failure, the risk-reducing potential of OBS activities indicates that additional capital requirement of OBS activities will penalize large banks.