Banks' option to lend,interest rate sensitivity,and credit availability |
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Authors: | Hasan Iftekhar Sarkar Sudipto |
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Institution: | (1) Rensselaer Polytechnic Institute and Federal Reserve Bank of Atlanta, Lally School of Management, RPI, Troy, NY, 12180;(2) DeGroote School of Business, McMaster University, 1280 Main Street West, Hamilton, ON, L8S 4M4, Canada |
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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 generally
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 (or 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.
This revised version was published online in June 2006 with corrections to the Cover Date. |
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Keywords: | Bank's lending capacity interest rate risk maturity intermediation option to lend |
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