Complementarities Between Loan Sales And Standby Letters Of Credit: A Theoretical Model

In their traditional function, commercial banks engage in recourse loan sales while evaluating clients’ creditworthiness and assuming risk. However, banks face regulatory constraints that prevent them from fully exploiting this activity. Loan sales with recourse are treated as deposits, and selling banks are required to hold additional reserves at the Fed; they are also subjected to higher capital requirements and must make additional FDIC deposit insurance premiums. By contrast, standby letters of credit and loan sales without recourse are considered off-balance-sheet items and are not subject to the aforementioned regulatory requirements. This paper uses the time-state preference model to demonstrate that the cash flow structures of recourse loan sales can be replicated by constructing portfolios consisting of non-recourse loan sales and standby letters of credit. Our theoretical model contributes to the existing literature by illustrating how banks can combine loan sales without recourse with standby letters of credit as complementary risk-management and cost-reduction instruments.