Off-Balance Sheet Funding, Voluntary Support and Investment Efficiency

Abstract

Financing an investment off-balance sheet gives a bank the option, but not the obligation, to voluntarily support debt repayments using its on-balance sheet funds when the investment fails. Such flexibility, which is absent with on-balance sheet funding, allows the bank to signal information about the quality of its future projects, improving investment efficiency. Yet, off-balance sheet funding reduces the bank's skin-in-the-game and effort incentives. Off-balance sheet funding with voluntary support is optimal for activities that are rapidly growing or negatively correlated with existing assets. The model yields testable predictions on the relationship between off-balance
sheet debt spreads and sponsors' characteristics.

Keywords: off-balance sheet funding, voluntary support, signaling, optimal funding mode

JEL Classification: D8, G11, G2