Demand of Flexibility and Bank Loan Decisions-A Real Option Approach

Abstract

Under the loan capacity constraint, a regulatory bank should extend its loans to full capacity when the constraint is binding. When future interest rates are uncertain, a risk-averse bank under constraint might reduce its current loan level and reserve its funds for future lending; this practice is referred to as the ”demand of flexibility”. The demand is positive provided that the marginal profit of future lending is expected to be greater than that of current lending, and it results in a choice of loan level which falls below the regulatory constraint (the ”under-loan problem”). When liability management is allowed, the demand is negative in cases where the marginal profit of future lending is expected to be less than that of current lending, and it leads to a choice of loan level which exceeds the regulatory constraint (the ”over-loan problem.”) The use of forward loans (loan commitments) can replace a bank's demand of flexibility and reduce its incentive to either under-loan or over-loan. In contrast, however, it is found in this paper that the deregulation of reserve or capital requirements are a less effective tool in solving such problems.