Despite operating under substantial regulatory constraints, we find that commercial
banks manage their investments largely consistent with the predictions of portfolio choice
models with capital market imperfections. Based on 1990-2002 data for small (assets less than
$1 billion) U.S. commercial banks, net new lending to the business, real estate, and consumer
sectors increased with expected sector profitability, tended to decrease with the illiquidity of
existing (overhanging) loan stocks, and was responsive to correlations in cross-sector returns.
Small banks are most appropriate for this study, because they make illiquid loans and manage
risk via on-balance sheet (non-hedged) diversification strategies.