Real Options: a Commercial Bank Lending Application

Abstract

We extend existing real-option theories by incorporating the stochastic interaction be tween unit price and cost, applied in commercial bank lending. We further empirically examine an implication derived from the model as to the relationship between lending practices in the banking industry and future uncertainties. We focus on lending institutions to analyze the effect of uncertainties on lending (investment) decisions for several reasons. First, it is easy to identify the main sources of uncertainties for the assets and liabilities of the financial institutions - default risk and interest rate changes. Second, the commercial lending institution provides a unique environment in which the correlation between investment costs (liabilities) and output (loans) price is quite high and positive since both depend heavily on interest rates. Finally, bank loans may be subject to a high degree of irreversibility (e.g., substantial loss in defaults). The real option mode l explains the relationship between levels of lending, loan-to-assets, and the uncertainties regarding interest income and expenses. The correlation be tween interest income and loan expenses, in particular, explains cross- sectional loan activities, which confirms the importance of risk management. These results also show that as banks increase one type of risk, e .g., interest rate risk, they decrease another type of risk, e .g ., lending risk as measured by loans/assets.