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

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  • Hasan , Iftekhar

    ()
    (Rensselaer Polytechnic Institute and Bank of Finland Research)

  • Sarkar, Sudipto

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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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0215.pdf
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Bibliographic Info

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
Web page: http://www.suomenpankki.fi/en/
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Keywords: interest rate risk; option to lend; bank’s lending capacity; maturity intermediation;

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  1. Santomero, Anthony M, 1984. "Modeling the Banking Firm: A Survey," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 576-602, November.
  2. Schwartz, Eduardo S., 1977. "The valuation of warrants: Implementing a new approach," Journal of Financial Economics, Elsevier, vol. 4(1), pages 79-93, January.
  3. Pearson, Neil D & Sun, Tong-Sheng, 1994. " Exploiting the Conditional Density in Estimating the Term Structure: An Application to the Cox, Ingersoll, and Ross Model," Journal of Finance, American Finance Association, vol. 49(4), pages 1279-1304, September.
  4. Edward J. Kane, 1981. "Accelerating Inflation, Technological Innovation, and the Decreasing Effectiveness of Banking Regulation," NBER Working Papers 0638, National Bureau of Economic Research, Inc.
  5. Jin-Chuan, Duan & Moreau, Arthur F. & Sealey, C. W., 1995. "Deposit insurance and bank interest rate risk: Pricing and regulatory implications," Journal of Banking & Finance, Elsevier, vol. 19(6), pages 1091-1108, September.
  6. Hancock, Diana, 1985. "Bank Profitability, Interest Rates, and Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 17(2), pages 189-202, May.
  7. Flannery, Mark J, 1981. "Market Interest Rates and Commercial Bank Profitability: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 36(5), pages 1085-1101, December.
  8. Hutchison, David E. & Pennacchi, George G., 1996. "Measuring Rents and Interest Rate Risk in Imperfect Financial Markets: The Case of Retail Bank Deposits," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(03), pages 399-417, September.
  9. Mark Flannery & Christopher James, . "Market Evidence on the Effective Maturity of Bank Assets and Liabilities," Rodney L. White Center for Financial Research Working Papers 05-83, Wharton School Rodney L. White Center for Financial Research.
  10. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  11. Gerald A Hanweck & Thomas Eric Kilcollin, 1981. "Bank profitability and interest rate risk," Research Papers in Banking and Financial Economics 51, Board of Governors of the Federal Reserve System (U.S.).
  12. Jaffee, Dwight M., 1986. "Term structure intermediation by depository institutions," Journal of Banking & Finance, Elsevier, vol. 10(2), pages 309-325, June.
  13. Hull, John & White, Alan, 1990. "Valuing Derivative Securities Using the Explicit Finite Difference Method," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(01), pages 87-100, March.
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Cited by:
  1. 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.
  2. Kauko, Karlo, 2002. "Links between securities settlement systems: An oligopoly theoretic approach," Research Discussion Papers 27/2002, Bank of Finland.
  3. 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.
  4. Mikko Niskanen, 2004. "Lender of last resort and the moral hazard problem," Macroeconomics 0405016, EconWPA.
  5. Peik Granlund, 2004. "Bank exit legislation in US, EU and Japanese financial centres," Finance 0405015, EconWPA.

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