Capital and Off-Balance Sheet Credit Risk of Us Banks

This study examines the relationship between bank capital, and on- and off-balance sheet credit risk for banks in the United States over 2001-2008. It is found that capital and off-balance sheet credit risk are simultaneously and positively determined. Banks with more capital are able to take more off-balance sheet credit risk or securitize more loans. Likewise, banks that securitize more loans have to increase capital in order to absorb unexpected losses arising from off-balance sheet credit risk. However, only off-balance sheet credit risk exogenously and positively determines on-balance sheet credit risk. There is stronger evidence of simultaneous determination of risk and capital decisions for change in total equity capital ratio than for total risk-based capital ratio. With respect to the effectiveness of capital standards, undercapitalized banks are induced to increase total equity capital ratio but also take on more off-balance sheet credit risk with the result that total risk-based capital ratio declines