A METHODOLOGICAL INVESTIGATION OF RISK EXPOSURE OF BANK OFF-BALANCE SHEET LOAN COMMITMENT ACTIVITIES

This study provides further empirical evidence of capital market react ions to the growth and riskiness of bank off-balance sheet loan commit ment activities. Previous studies have ignored the impact of regulatio n on the measurement of bank risk. In this research Ronn-Verma (1986) and Gorton-Santomero (1990) option pricing models are employed to calc ulate 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 add ition, decreases in equity risk, subordinated debt default risk and im plied asset risk resulting from increases in loan commitments activiti es implies that loan commitments may contribute to the overall diversi fication of bank portfolio risk. It, therefore, may be inappropriate t o include loan commitments in a risk-based capital calculation.