Bank financing and investment decisions with asymmetric information about loan quality

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. We model 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 riskless securities against future liquidity needs depends on both the regulatory environment and the informational structure. If banks are ex ante identical, they prefer issuing risky debt to fund a withdrawal to holding riskless securities ex ante. If banks have partial knowledge of loan quality, however, high-quality banks may hold riskless securities to signal their quality, enabling them to issue risky debt at a lower interest rate. We present new empirical evidence that banks with higher asset quality do in fact hold more cash and securities.