A decision making problem in the banking industry

Abstract

The main categories of assets held by banks are risky assets (loans and intangible assets), Treasuries (bonds issued by the national Treasury) and reserves. Our contribution models how decisions about the allocation of available funds to the former two types are dependent on perceptions about risk and regret. Our discussion is based on utility theory where a regret attribute is considered alongside a risk component as an integral part of the objective function. Preferences among risky assets and Treasuries are described by the maximization of the expected value of a utility function that depends on the funds available to the bank. Moreover, we conjecture that anticipated disutility from regret can dramatically impact the choices of assets types that risk-and regret-averse banks decide to hold. Here we conclude that, compared with the risk-averse case, the bank who takes regret into account will be exposed to higher credit and market risk when the difference between the expected return on risky assets and the Treasuries rate is small but lower risk exposure when this difference is high. We also assess how regret can influence a bank's view of rate of return loan guarantees, as measured by its willingness-to-incur-costs (WTIC) that are related to the screening and monitoring of debtor and guarantor status. We find that regret increases the regret-averse bank's WTIC for a guarantee when the asset portfolio is relatively risky, but decreases when the portfolio is considered to be safe. A feature of our contribution is that the main issues are briefly analysed and, where possible, the outcomes are represented graphically. In this regard, we comment on the claim that an investment away from risky assets towards Treasuries is responsible for credit crunches in the banking industry.