Abstract
This paper examines the incentives banks have to engage in ‘off balance sheet’ activities such as commercial loan sales and the issuance of standby letters of credit (SLCs). I show that loan sales and loans backed by SLCs have payoff characteristics similar to secured debt. Like secured debt, off balance sheet activities permit banks to sell a portion of the cash flows associated with new investment oppurtunities. This ability permits banks to invest in loans with positive net present values that they would pass up if restricted to deposit financing. An examination of the risk premium on large certificates of deposit provides evidence consistent with the model.
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