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

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

Author Info

Hasan , Iftekhar () (Rensselaer Polytechnic Institute and Bank of Finland Research)
Sarkar, Sudipto

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Iftekhar Hasan

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 usually 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 (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.

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Paper provided by Bank of Finland in its series Research Discussion Papers with number 15/2002.

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Length: 58 pages
Date of creation: 08 Jul 2002
Date of revision:
Handle: RePEc:hhs:bofrdp:2002_015

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
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Article
- Iftekhar Hasan & Sudipto Sarkar, 2002. "Banks' option to lend, interest rate sensitivity, and credit availability," Review of Derivatives Research, Springer, vol. 5(3), pages 213-250, October. [Downloadable!] (restricted)

Find related papers by JEL classification:
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

Kauko, Karlo, 2002. "Links between securities settlement systems: An oligopoly theoretic approach," Research Discussion Papers 27/2002, Bank of Finland. [Downloadable!]
Granlund , Peik, 2002. "Bank exit legislation in US, EU and Japanese financial centres," Research Discussion Papers 25/2002, Bank of Finland. [Downloadable!]
Peik Granlund, 2004. "Bank exit legislation in US, EU and Japanese financial centres," Finance 0405015, EconWPA. [Downloadable!]
Mikko Niskanen, 2004. "Lender of last resort and the moral hazard problem," Macroeconomics 0405016, EconWPA. [Downloadable!]
Matti Keloharju & Markku Malkamäki & Kjell G. Nyborg & Kristian Rydqvist, 2004. "A descriptive analysis of the Finnish treasury bond market 1991–1999," Finance 0405017, EconWPA. [Downloadable!]
Other versions:
- Keloharju, Matti & Malkamäki, Markku & Nyborg, Kjell G. & Rydqvist, Kristian, 2002. "A descriptive analysis of the Finnish treasury bond market 1991–1999," Research Discussion Papers 16/2002, Bank of Finland. [Downloadable!]
Karlo Kauko, 2004. "Links between securities settlement systems: An oligopoly theoretic approach," Industrial Organization 0405003, EconWPA. [Downloadable!]

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