An Empirical Analysis of Bank Standby Letters of Credit Risk

Bank exposure to off‐balance sheet activities in general and Standby Letters of Credit (SLCs) in particular has become a major concern to regulators. The risk‐exposure of SLCs has been re‐examined by employing option pricing methodologies to calculate implied asset risk from bank equity and flat deposit insurance, and from risk‐premia on bank subordinated debt. The results indicate that SLC reduce systematic risk, equity risk, and implied asset risk. It appears that Standby Letters of Credit contribute to the overall diversification of bank's assets.