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

38 Pages Posted: 27 Apr 2000 Last revised: 15 Aug 2021

Date Written: October 1987

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

Lucas, Deborah J. and McDonald, Robert L., Bank Portfolio Choice with Private Information About Loan Quality: Theory and Implications for Regulation (October 1987). NBER Working Paper No. w2421, Available at SSRN: https://ssrn.com/abstract=227116

Deborah J. Lucas (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8333 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER)

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Robert L. McDonald

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8344 (Phone)
847-491-5719 (Fax)

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