Commercial banks play a central role in the supply of credit. About one-third of all household debt is obtained from commercial banks, and about two-fifths of all small businesses obtain some form of credit from a commercial bank. Recent theory suggests that, when external finance is costly, value-maximizing banks make asset allocation and capital budgeting decisions in a risk-averse manner: they base new lending decisions not only on expected loan returns, but also on their available capital and on the covariance of these returns with their existing loan portfolio.
Such behavior increases a bank's expected profit by reducing the probability that the bank finds itself with too little internal capital to fund a valuable loan in the future. This theorized behavior also affects borrowers, particularly small business borrowers who rely primarily on commercial bank lending for financing: in the long run, their bank is more likely to be around to finance them, but in the short run, they may face credit rationing during periods of high effective bank risk aversion.
In this paper, we investigate whether small commercial banks' lend in a manner consistent with this risk management and capital budgeting paradigm. As just noted, commercial banks provide vital access to capital and credit for small businesses and consumers, and this is especially true of small, locally focused commercial banks—even though these so-called "community banks" represent a relatively small share of total credit supply, they are a critical source of funding for informationally opaque small businesses and as such are important for economic growth.
We focus on the effect of 'risk overhang,' the risk represented by illiquid, outstanding loan stocks on net new lending. Because banks act as delegated monitors, they have private information about their loans that can lead to lemons problems if they attempt to sell the loans.
