Are Loan Sales Really Off-Balance Sheet

A commercial loan sale or secondary loan participation is a contract under which a bank sells the cash stream from a loan to a third party, usually without recourse. In accordance with accepted accounting procedures, this no--recourse contract allows removal of the underlying loan from the balance sheet of the bank, so that the funding of the loan is not subject to capital or reserve requirements. Since commercial banks are thought to specialize in the origination of non-marketable claims on borrowing firms, the apparent ability of banks to sell these assets seems paradoxical. The paradox could be explained if loan sales contracts contained implicit guarantees in the form of options by loan buyers to sell the loans back to the bank if the underlying borrower performs worse than anticipated. If such guarantees exist, then loans which are sold represent contingent liabilities, and a rationale for increasing capital requirements may exist. As an indirect test of the existence of this guarantee, we investigate whether loan sales and commercial paper prices contain a risk premium for the default of the selling bank. The empirical evidence supports the hypothesis of implicit guarantees.