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Bank Financing and Investment Decisions with Asymmetric Information

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  • Deborah Lucas
  • Robert L. McDonald

Abstract

Banks know more about the quality of their assets than do outside investors. This informational asymmetry can distort investment decisions if the bank must raise funds from uninformed outsiders, and assets sold will be subject to a lemons discount. Using a three-period equilibrium model we examine the effect of asymmetric information about loan quality on the asset and liability decisions of banks and the market valuation of bank liabilities. The existence of a precautionary demand for T-bills against future liquidity needs depends both on the regulatory environment and the informational structure. If banks are ex ante identical, issuing risky debt to fund a deposit outflow is preferred to holding T-bills ex ante. However, if banks have partial knowledge of loan quality, and if their asset choice is observable, they may hold T-bills to signal their quality, enabling them to issue risky debt at a lower interest rate.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2422.

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Date of creation: Oct 1987
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Handle: RePEc:nbr:nberwo:2422

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  1. Thakor, Anjan V., 1982. "Toward a theory of bank loan commitments," Journal of Banking & Finance, Elsevier, vol. 6(1), pages 55-83, March.
  2. Hart, Oliver D & Jaffee, Dwight M, 1974. "On the Application of Portfolio Theory to Depository Financial Intermediaries," Review of Economic Studies, Wiley Blackwell, vol. 41(1), pages 129-47, January.
  3. Baltensperger, Ernst, 1974. "The Precautionary Demand for Reserves," American Economic Review, American Economic Association, vol. 64(1), pages 205-10, March.
  4. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
  5. Frost, Peter A, 1971. "Banks' Demand for Excess Reserves," Journal of Political Economy, University of Chicago Press, vol. 79(4), pages 805-25, July-Aug..
  6. Koehn, Michael & Santomero, Anthony M, 1980. " Regulation of Bank Capital and Portfolio Risk," Journal of Finance, American Finance Association, vol. 35(5), pages 1235-44, December.
  7. Joseph Stiglitz & Andrew Weiss, 1990. "Sorting Out the Differences Between Signaling and Screening Models," NBER Technical Working Papers 0093, National Bureau of Economic Research, Inc.
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Cited by:
  1. Chan, Yuk-Shee & Greenbaum, Stuart I & Thakor, Anjan V, 1992. " Is Fairly Priced Deposit Insurance Possible?," Journal of Finance, American Finance Association, vol. 47(1), pages 227-45, March.
  2. Lucas, Deborah & McDonald, Robert L., 1987. "Bank portfolio choice with private information about loan quality : Theory and implications for regulation," Journal of Banking & Finance, Elsevier, vol. 11(3), pages 473-497, September.

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