Abstract
Prior tests of the underinvestment hypothesis, as an explanation of why banks use off-balance sheet direct credit substitutes, are deficient in econometric technique and in their use of U.S. data which is likely to be strongly distorted by regulation. In contrast we test the hypothesis on Australian data which is relatively free of the regulatory distortions affecting prior studies and examine two types of off-balance sheet direct credit substitutes, namely standby letters of credit and bill endorsements. The empirical results lend support to the underinvestment hypothesis.
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