Bank regulators are concerned with the dramatic increase and risk exposure of Off-Balance Sheet (OBS) banking activities in recent years, and proposed that some OBS activities be included in the calculation of a risk-based capital requirement. This paper investigates the riskiness of OBS activities. Specifically, this paper reports on three capital market tests of OBS banking risk: the impact of OBS activities on the risk-premia of subordinated debt, on equity risk and on systematic risk of large commercial banks and bank holding companies. The underlying premise of this study is that the bank stockholders and subordinated debtholders are more exposed to the risk of bank failure resulting from OBS banking risk than insured and uninsured depositholders. If OBS activities are significantly related to market measures of bank risk, then "market discipline" of such activities exists. The empirical literature, to date, has ignored the impact of OBS banking risk on the default risk-premia borne by subordinated debtholders. The results indicate that most OBS activities reduce risk-premia and equity risk, but do not affect systematic risk. Both stockholders and subordinated debtholders price these OBS activities as risk-reducing. Therefore, regulatory interference in the form of additional capital requirement of OBS activities will penalize large commercial banks and will create distortions in the financial intermediation market.
Hassan, M. Kabir, "An empirical investigation of the existence of "market discipline" of off-balance sheet banking risk" (1991). Department of Economics and Finance Working Papers, 1991-2006. Paper 49.