Bank Financing and Investment Decisions with Asymmetric Information

38 Pages Posted: 29 Dec 2006 Last revised: 14 Feb 2021

Date Written: October 1987

Abstract

Banks know more about the quality of their assets than do outside investors. This informational asymmetry can distort investment decisions if the bank must raise funds from uninformed outsiders, and assets sold will be subject to a lemons discount. Using a three-period equilibrium model we examine the effect of asymmetric information about loan quality on the asset and liability decisions of banks and the market valuation of bank liabilities. The existence of a precautionary demand for T-bills against future liquidity needs depends both on the regulatory environment and the informational structure. If banks are ex ante identical, issuing risky debt to fund a deposit outflow is preferred to holding T-bills ex ante. However, if banks have partial knowledge of loan quality, and if their asset choice is observable, they may hold T-bills to signal their quality, enabling them to issue risky debt at a lower interest rate.

Suggested Citation

Lucas, Deborah J. and McDonald, Robert L., Bank Financing and Investment Decisions with Asymmetric Information (October 1987). NBER Working Paper No. w2422, Available at SSRN: https://ssrn.com/abstract=349226

Deborah J. Lucas (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
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847-491-8333 (Phone)
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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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