Fixed versus variable rate loans under regret aversion

This paper examines the optimal mix of fixed and variable rate loans of a competitive bank facing funding cost uncertainty, where the bank is not only risk averse but also regret averse. Regret aversion is characterized by a utility function that includes disutility from having chosen ex-post suboptimal alternatives. We show that a negative spread between fixed and variable rate loans is a necessary but not sufficient condition for the dominance of variable rate loans over fixed rate loans. If the bank optimally extends both fixed and variable rate loans, the total amount of loans depends neither on the bank's regret aversion nor on the funding cost uncertainty. The bank, however, optimally lends less should it be forced to assume the entire funding cost uncertainty by exclusively extending fixed rate loans. Finally, using a two-state example, we show that the bank optimally extends more (less) fixed rate loans than in the case of pure risk aversion if the high (low) marginal cost of funds is more likely to prevail. Regret aversion as such plays a crucial role in determining the bank's optimal choice between fixed and variable rate loans.