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Banks' option to lend, interest rate sensitivity, and credit availability

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  • Iftekhar Hasan

    ()

  • Sudipto Sarkar

    ()

Abstract

Interest rate risk is a major concern for banks because of the nominal nature of their assets and the asset-liability maturity mismatch. This paper proposes a new way to derive a bank's interest rate sensitivity, by examining separately the effects of interest rate changes on existing loans(loans-in-place) and potential loans (loans-in-process). A potential loan is shown to be equivalent to an American option to lend, and is valued using option theory. An increase in interest rates generally has a negative effect on existing loans. However, if both deposit and lending rates rise by the same amount, the value of a potential loan generally increases. Hence a bank's lending slack (or ratio of loans-in-process to loans-in-place) will determine its overall interest rate risk. Empirical evidence indicates that low-slack banks indeed have significantly more interest rate risk than high-slack banks. The model also makes predictions regarding the effect of deposit and lending rate parameters on bank credit availability. Empirical tests with quarterly data are generally supportive of these predictions. Copyright Kluwer Academic Publishers 2002

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Bibliographic Info

Article provided by Springer in its journal Review of Derivatives Research.

Volume (Year): 5 (2002)
Issue (Month): 3 (October)
Pages: 213-250

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Handle: RePEc:kap:revdev:v:5:y:2002:i:3:p:213-250

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Web page: http://www.springerlink.com/link.asp?id=102989

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Keywords: Bank's lending capacity; interest rate risk; maturity intermediation; option to lend;

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Cited by:
  1. Mikko Niskanen, 2004. "Lender of last resort and the moral hazard problem," Macroeconomics 0405016, EconWPA.
  2. Peik Granlund, 2004. "Bank exit legislation in US, EU and Japanese financial centres," Finance 0405015, EconWPA.
  3. Matti Keloharju & Markku Malkamäki & Kjell G. Nyborg & Kristian Rydqvist, 2004. "A descriptive analysis of the Finnish treasury bond market 1991–1999," Finance 0405017, EconWPA.
  4. Karlo Kauko, 2004. "Links between securities settlement systems: An oligopoly theoretic approach," Industrial Organization 0405003, EconWPA.
  5. Lin, Jane-Raung & Chung, Huimin & Hsieh, Ming-Hsiang & Wu, Soushan, 2012. "The determinants of interest margins and their effect on bank diversification: Evidence from Asian banks," Journal of Financial Stability, Elsevier, vol. 8(2), pages 96-106.

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