Portfolio Risks and Bank Asset Choice

This paper investigates the effects of both credit risk and interest-rate risk on bank portfolio choices. It presents a model of banking that explains portfolio risks with informational asymmetries; depositors cannot observe the returns on bank loans and banks cannot observe depositors’ liquidity needs. - Bank capital must cover possible losses due to loan default and high future deposit costs given the maturity imbalance of bank portfolios. We show how bank capital inadequacy may prevent a bank from investing in the optimal portfolio and how the efficiency of the bank’s intermediation technology affects its choice of second-best portfolio.