Bank portfolio choice with private information about loan quality. Theory and implications for regulation

Deborah Lucas*, Robert McDonald

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

13 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)473-497
Number of pages25
JournalJournal of Banking and Finance
Volume11
Issue number3
DOIs
StatePublished - Jan 1 1987

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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