Banks

Financial Institutions Center

Risk Management, Capital Structure and Lending at Banks
by A. Sinan Cebenoyan Philip E. Strahan 02-09

The Wharton Financial Institutions Center

The Wharton Financial Institutions Center provides a multi-disciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. TheCenter's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that itsresearch is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest.

Franklin Allen Co-Director

Richard J. HerringCo-Director

The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation

Risk Management, Capital Structure and Lending at Banks

A. Sinan Cebenoyan Professor of Finance Frank G. Zarb School of Business Hofstra University Hempstead, NY 11549 finazc@hofstra.edu (516) 463-5702

Philip E. Strahan Boston College, Carroll School of Management & SloanFellow, Wharton Financial Institutions Center 324b Fulton Hall 140 Commonwealth Ave. Chestnut Hill, MA 02467 (617) 552-6430 philip.strahan@bc.edu

October 2001

Abstract We test how active management of bank credit risk exposure through the loan sales market affects capital structure, lending, profits, and risk. We find that banks that rebalance their C&I loan portfolio exposures by both buyingand selling loans – that is, banks that use the loan sales market for risk management purposes rather than to alter their holdings of loans -- hold less capital than other banks; they also make more risky loans (loans to businesses) as a percentage of total assets than other banks. Holding size, leverage and lending activities constant, banks active in the loan sales market have lower risk andhigher profits than other banks. We conclude that increasingly sophisticated risk management practices in banking are likely to improve the availability of bank credit but not to reduce bank risk.

Risk Management, Capital Structure and Lending at Banks

I. Introduction

It is difficult to imagine another sector of the economy where as many risks are managed jointly as in banking. By itsvery nature, banking is an attempt to manage multiple and seemingly opposing needs. Banks stand ready to provide liquidity on demand to depositors through the checking account and to extend credit as well as liquidity to their borrowers through lines of credit (Kashyap, Rajan, and Stein, 1999). Because of these fundamental roles, banks have always been concerned with both solvency and liquidity.Traditionally, banks held capital as a buffer against insolvency, and they held liquid assets – cash and securities – to guard against unexpected withdrawals by depositors or draw downs by borrowers (Saidenberg and Strahan, 1999). In recent years, risk management at banks has come under increasing scrutiny. Banks and bank consultants have attempted to sell sophisticated credit risk managementsystems that can account for borrower risk (e.g. rating), and, perhaps more important, the risk-reducing benefits of diversification across borrowers in a large portfolio. Regulators have even begun to consider using banks’ internal credit models to devise capital adequacy standards. Why do banks bother? In a Modigliani –Miller world, firms generally should not waste resources managing risks because...