Loan Commitments and Bank Risk Exposure

Loan commitments increase a bank’s risk by obligating it to issue future loans under terms that it might otherwise refuse. However, moral hazard and adverse selection problems potentially may result in these contracts being rationed or sorted. Depending on the relative risks of the borrowers who do and do not receive commitments, commitment loans could be safer or riskier on average than other loans. The empirical results indicate that commitment loans tend to have slightly better than average performance, suggesting that commitments generate little risk or that this risk is offset by the selection of safer borrowers.