Working Paper: NBER ID: w2421
Authors: 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.
Keywords: Banking; Portfolio Choice; Regulation; Asymmetric Information
JEL Codes: G21; D82
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| private information about loan quality (G21) | banks' asset choices (G21) |
| increase in equity requirements (G32) | increase in bank safety (G28) |
| increase in equity requirements (G32) | ambiguous effect on overall bank safety (G21) |
| changes in capital requirements (G28) | bankruptcy risk (G33) |
| liquidity costs arise from private information about loan quality (G33) | selling risky assets (G19) |
| bank's equity position (G21) | risk profile of its assets (G32) |