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Bank portfolio choice with private information about loan quality : Theory and implications for regulation

  • Lucas, Deborah
  • McDonald, Robert L.

This paper models bank asset choice when shareholders know more about loan quality than do outsiders. Because of this informational asymmetry, the price of loans in the secondary market is the price for poor quality loans. Banks desire to hold marketable securities in order to avoid liquidating good quality loans at the "lemons" price, but also have a countervailing desire to hold risky loans in order to maximize the value of deposit insurance. In this context, portfolio composition and bank safety is examined as a function of the market distribution of loan quality, and the distribution of deposits. The model suggests that off-balance sheet commitments have little effect on bankruptcy risk, and induce banks to hold more securities. We also show that an increase in the bank equity requirement will unambiguously increase bank safety in the long run. In the short run, banks are unambiguously riskier on-balance-sheet, although the effect on bank safety is ambiguous.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 11 (1987)
Issue (Month): 3 (September)
Pages: 473-497

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Handle: RePEc:eee:jbfina:v:11:y:1987:i:3:p:473-497
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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  1. William Poole, 1968. "Commercial Bank Reserve Management In A Stochastic Model: Implications For Monetary Policy," Journal of Finance, American Finance Association, vol. 23(5), pages 769-791, December.
  2. 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.
  3. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
  4. 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..
  5. Hawkins, Gregory D., 1982. "An analysis of revolving credit agreements," Journal of Financial Economics, Elsevier, vol. 10(1), pages 59-81, March.
  6. 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.
  7. Baltensperger, Ernst, 1974. "The Precautionary Demand for Reserves," American Economic Review, American Economic Association, vol. 64(1), pages 205-10, March.
  8. Deborah Lucas & Robert L. McDonald, 1987. "Bank Financing and Investment Decisions with Asymmetric Information," NBER Working Papers 2422, National Bureau of Economic Research, Inc.
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