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Loan Portfolio Management and Liquidity Risk: The Impact of Limited Liability and Haircut

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  • Deb Narayan Barik

    (Indian Institute of Technology Guwahati)

  • Siddhartha P. Chakrabarty

    (Indian Institute of Technology Guwahati)

Abstract

In this article, we consider the problem of a bank’s loan portfolio in the context of liquidity risk, while allowing for the limited liability protection enjoyed by the bank. Accordingly, we construct a novel loan portfolio model with limited liability, while maintaining a threshold level of haircut in the portfolio. For the constructed three-time step loan portfolio, at the initial time, the bank raises capital via debt and equity, investing the same in several classes of loans, while at the final time, the bank either meets its liabilities or becomes insolvent. At the intermediate time step, a fraction of the deposits are withdrawn, resulting in liquidation of some of the bank’s assets. We have proposed a liquidation strategy that minimizes liquidation cost and also reduces liquidation of the safe asset, thereby reducing the risk of default. Our theoretical results show that the model with the haircut constraint leads to lesser liquidity risk, as compared to the scenario of no haircut constraint being imposed. Finally, we present numerical results to illustrate the theoretical results which were obtained.

Suggested Citation

  • Deb Narayan Barik & Siddhartha P. Chakrabarty, 2025. "Loan Portfolio Management and Liquidity Risk: The Impact of Limited Liability and Haircut," Journal of Quantitative Economics, Springer;The Indian Econometric Society (TIES), vol. 23(3), pages 713-734, September.
    • Handle: RePEc:spr:jqecon:v:23:y:2025:i:3:d:10.1007_s40953-025-00442-0
    DOI: 10.1007/s40953-025-00442-0
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