Off-balance sheet activities and bank default-risk premia: A comparison of risk measures

This paper examines the market discipline of off-balance sheet activities on the default-risk premia of subordinated bank debt. The standard approach for determining whether market prices of subordinated debt reflect the risk of default is to regress the yield spread against accounting measures of bank risk. This approach may be inadequate because yield spreads are neither linear nor monotonic functions of bank risk. Moreover, the standard approach fails to consider that banks are regulated. This paper compares this approach and one where risk is measured with a contingent claims pricing model. 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 may be overly concerned with the risk exposure of off-balance sheet banking activities.