Unveiling Risk on Bank Balance Sheets: From Risk Disclosure to Credit Reallocation

We examine how banks adjust credit allocation when hidden credit risk is revealed. Using supervisory risk disclosure data from the European Central Bank’s 2014 Asset Quality Review, we find that banks experiencing larger increases in non-performing loans and provisions significantly reduce riskweighted exposures while keeping total credit volumes largely unchanged. This suggests that derisking primarily occurs through portfolio reallocation - particularly within portfolios - rather than through credit contraction. We document heterogeneous responses depending on the rating approach used to measure credit risk and we show that capital constraints amplify, but are not the sole drivers of, de-risking. Finally, we provide evidence that supervisory risk disclosure plays a key role in shaping banks’ risk-taking behavior, even in the absence of observable adjustments in their financial statements.