Bank portfolio choice with private information about loan quality: Theory and implications for regulation |
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| Institution: | 1. Department of Economics, University of North Texas, 1155 Union Circle Box 311457, Denton, TX 76203, USA;2. Wenlan School of Business, Zhongnan University of Economics and Law, Wuhan, Hubei 430073, China;1. CITIC research center, University of A Coruña, Spain;2. M2NICA research group, Department of Mathematics, University of A Coruña, Spain;3. Department of Econometrics, Statistics and Applied Economics, University of Barcelona, Spain;1. German Institute for Economic Research (DIW Berlin), Mohrenstr. 58, Berlin 10117, Germany;2. Humboldt University of Berlin (HU Berlin), Spandauer Str. 1, Berlin 10178, Germany;1. Department of Environmental Studies, Masaryk University, Brno, Czech Republic;2. Division of Resource Economics, Department of Agricultural Economics, Humboldt-Universität zu Berlin, Unter den Linden, 6, 10099 Berlin, Germany;3. Institut de Ciència i Tecnologia Ambientals (ICTA), Universitat Autònoma de Barcelona (UAB), 08193, Bellaterra, Barcelona, Spain;1. College of Economics, Zhejiang University, Hangzhou, China;2. Department of Finance, Black School of Business, Penn State Behrend, Erie, PA 16563, USA;3. AP Research, Penn State Behrend, Erie, PA 16563, USA;4. Department of Finance, Spears School of Business, Oklahoma State University, Stillwater, OK 74078, USA |
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| Abstract: | 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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