Off-balance-sheet activity under adverse selection: The European experience

In the crisis that started in 2007, banks’ off-balance sheet activity has been blamed for flooding the market with low-quality assets and contributing to spreading risk throughout the economic system. Nevertheless, this view is hardly sustainable within the context of sophisticated markets. This paper puts forward an alternative interpretation of the off-balance sheet market, the so-called adverse selection hypothesis. According to this hypothesis, an adverse selection problem characterizes the relation between banks and their counterparties in off-balance sheet deals. Empirically, this implies that off-balance sheet activity is expected to be negatively related to failure risk, whereas it is expected to be positively related to the quality of the assets used for off-balance sheet operations. We test the adverse selection hypothesis for a sample of banks in the 27 member countries of the European Union during the pre-crisis period 1996–2006 and the crisis period 2007–2009. In addition, we check for possible differences between banks in the first 15 members of the European Union and those in the 12 new members.

► The operation of the EU banking market for off-balance sheet items is analyzed in terms of an adverse selection problem.
► This problem implies that high quality assets issued by high quality banks are predominant in the off-balance sheet activity of banks.
► Bank behavior in the first 15 members of the EU is consistent with the adverse selection hypothesis during the pre-crisis and crisis periods.
► The market discipline hypothesis provides a better explanation for the behavior of banks in the 12 new members of the EU.