Research Discussion Papers, Bank of Finland
Banks’ option to lend, interest rate sensitivity, and credit availability
() and Sudipto Sarkar
Abstract: Interest rate risk is a major concern for banks because of
the nominal nature of their assets and the asset-liability maturity
mismatch. This paper proposes a new way to derive a bank’s interest rate
sensitivity, by examining separately the effects of interest rate changes
on existing loans (loans-in-place) and potential loans (loans-in-process).
A potential loan is shown to be equivalent to an American option to lend,
and is valued using option theory. An increase in interest rates usually
has a negative effect on existing loans. However, if both deposit and
lending rates rise by the same amount, the value of a potential loan
generally increases. Hence a bank’s lending slack (ratio of
loans-in-process to loans-in-place) will determine its overall interest
rate risk. Empirical evidence indicates that low-slack banks indeed have
significantly more interest rate risk than high-slack banks. The model also
makes predictions regarding the effect of deposit and lending rate
parameters on bank credit availability. Empirical tests with quarterly data
are generally supportive of these predictions.
Keywords: interest rate risk; option to lend; bank’s lending capacity; maturity intermediation; (follow links to similar papers)
JEL-Codes: G13; G21; (follow links to similar papers)
58 pages, July 8, 2002
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