Portfolio adjustments under uncertainty: an application to agricultural financing by commercial banks

Abstract

In this study portfolio theory is used as the basis for a theoretical model from which theorems relating to bank behavior are deduced. Demand curves for assets are derived and are separated into income and substitution effects. The sign of the income effect is related to a decision maker's risk aversion coefficient. Some of the theoretical results imply that for the decreasingly risk averse banker, the demand for risky assets will increase with expected returns and decrease with variance. Cross price effects and covariance effects are shown to depend on whether assets are substitutes or complements in the portfolio model. Increasing the deposit feedback effect from loans will increase the demand for loan investments by the banker. And increasing the liquidity of assets (measured as the difference in the purchase and sale price of an asset in the current period) may increase or decrease the banker's holdings of risky assets; but for the banker with constant or increasing aversion to risk, the banker will decrease his holdings of risky assets. A quadratic programming model is constructed to demonstrate empirically the application of the theory to a particular bank. Variance and expected returns are calculated and a basic model solution is found using efficiency criteria discussed in the study. Equilibrium adjustments to changes in selected parameters are then observed and compared to previous model solutions. Finally, policy implications are made based on the theoretical model. Some issues considered relating to the impact on agricultural lending by banks were: seasonal borrowing privileges for rural banks from the Federal Reserve System, the development of secondary markets for bank's paper and increasing deposit costs..