A Reconciliation of the Evidence about Bank Lending with Portfolio Theory

Enzo Dia

No 56, Working Papers from University of Milano-Bicocca, Department of Economics

Abstract: A Markowitz portfolio model is developed in this paper, in order to show how the optimal portfolio is changed if the bank forecasts a shock. It is shown that monetary and real shocks result in quite different patterns of reaction by the bank and these results do not depend on the existence of market power. The model allows to study the effect of different degrees of diversification of the portfolio and shows that the smoothing of shocks increases with the concentration of the portfolio. The shock determines a shift of the composition of the portfolio of assets: the bank increases the share of the less volatile assets that have a lower return as they charge a lower rate to the firm. This phenomenon emerges whenever a variation of the interest rates of any asset affects the cost or the volatility of the asset too, so that equiproportional variations of the rates affect net return and variance of different assets in a different way. The benefits of this kind of behaviour decline with the availability of a wider range of assets. These results are consistent with all the most recent empirical evidence.

Pages: 35 pages
Date: 2002-09, Revised 2002-09
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