Bank Portfolio Management under Credit Market Imperfections
Journal of Mathematical Finance, 2020
31 Pages Posted: 13 May 2020
Date Written: April 18, 2020
This paper examines bank portfolio management under banking regulation and asymmetric information about borrower types and screening by banks and imperfect competition in the credit market. A bank tries to maximize expected profits subject to a portfolio variance constraint. The analysis yields the following results: For a monopoly bank, the incentive constraint of the efficient type of borrowers will be binding and the participation constraint of the inefficient type of borrowers will be binding. Further, given the variance constraint being binding, the optimal portfolio will be on the efficiency frontier. The paper also examines duopoly competition between aggressive (predator) and defensive (prey) banks and potential cooperation and reveals that among the alternatives of natural monopoly, entry deterrence, takeovers and efficient portfolio diversification through mergers or interest swaps, the cooperative efficient portfolio diversification strategy will dominate whenever portfolio returns are negatively correlated between any pair of interacting banks as it reduces portfolio variance for a given package of interest and loans.
Keywords: Banking, Portfolio Management, Adverse Selection
JEL Classification: E, F
Suggested Citation: Suggested Citation