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Bank Portfolio Choice with Private Information About Loan Quality: Theory and Implications for Regulation

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  • Deborah Lucas
  • Robert L. McDonald

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.

Suggested Citation

  • Deborah Lucas & Robert L. McDonald, 1987. "Bank Portfolio Choice with Private Information About Loan Quality: Theory and Implications for Regulation," NBER Working Papers 2421, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:2421
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    References listed on IDEAS

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    1. Frost, Peter A, 1971. "Banks' Demand for Excess Reserves," Journal of Political Economy, University of Chicago Press, vol. 79(4), pages 805-825, July-Aug..
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    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.
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    7. George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 84(3), pages 488-500.
    8. Hawkins, Gregory D., 1982. "An analysis of revolving credit agreements," Journal of Financial Economics, Elsevier, vol. 10(1), pages 59-81, March.
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    10. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
    11. 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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    Cited by:

    1. Freixas, Xavier & Gabillon, Emmanuelle, 1999. "Optimal Regulation of a Fully Insured Deposit Banking System," Journal of Regulatory Economics, Springer, vol. 16(2), pages 111-134, September.
    2. William P. Osterberg, 1990. "Bank capital requirements and leverage: a review of the literature," Economic Review, Federal Reserve Bank of Cleveland, vol. 26(Q IV), pages 2-12.
    3. Andrew Winton, 1996. "Monitored finance, liquidity, and institutional investment choice," Working Papers (Old Series) 9616, Federal Reserve Bank of Cleveland.
    4. Patrick Leoni, "undated". "Banking Regulation without Commitment to Audit," IEW - Working Papers 251, Institute for Empirical Research in Economics - University of Zurich.
    5. Banerjee, Saugata & Cadot, Olivier, 1996. "Syndicated lending under asymmetric creditor information," Journal of Development Economics, Elsevier, vol. 49(2), pages 289-306, May.
    6. Priyank Gandhi, 2018. "The relation between bank credit growth and the expected returns of bank stocks," European Financial Management, European Financial Management Association, vol. 24(4), pages 610-649, September.
    7. Lys, Thomas, 1996. "Abandoning the transactions-based accounting model: Weighing the evidence," Journal of Accounting and Economics, Elsevier, vol. 22(1-3), pages 155-175, October.

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