Risk Overhang and Loan Portfolio Decisions
42 Pages Posted: 23 Aug 2005
Date Written: August 2005
Despite operating under substantial regulatory constraints, we find that commercial banks manage their investments largely consistent with the predictions of portfolio choice models with capital market imperfections. Based on 1990-2002 data for small (assets less than $1 billion) U.S. commercial banks, net new lending to the business, real estate, and consumer sectors increased with expected sector profitability, tended to decrease with the illiquidity of existing (overhanging) loan stocks, and was responsive to correlations in cross-sector returns. Small banks are most appropriate for this study, because they make illiquid loans and manage risk via on-balance sheet (non-hedged) diversification strategies.
Keywords: commercial banks, loans, portfolio choice, risk overhang
JEL Classification: G11, G21
Suggested Citation: Suggested Citation