Journalof

BANKING &
FINANCE
E~E~ER Journal of Banking & Finance 21 (1997) 251-271

On the determinants of bank interest margins

under credit and interest rate risks
Kit Pong Wong *
School of Economics and Finance, University of Hong Kong, Pokfulam Road, Hong Kong
Received 28 January 1995; accepted 3 August 1996

Abstract

This paper explores the determinants of optimal bank interest margins based on a simple
firm-theoretical model under multiple sources of uncertainty and risk aversion. The model
demonstrates how cost, regulation, credit risk and interest rate risk conditions jointly
determine the optimal bank interest margin decision. We find that the bank interest margin
is positively related to the bank's market power, to the operating costs, to the degree of
credit risk, and to the degree of interest rate risk. An increase in the bank's equity capital
has a negative effect on the spread when the bank faces little interest rate risk. The effect of
rising interbank market rate on the spread is ambiguous and depends on the net position of
the bank in the interbank market. Our findings provide alternative explanations for the
empirical evidence concerning bank spread behavior.

JEL classification: G21

Keywords: Bank interest margins; Credit risk; Interest rate risk; Risk aversion

1. Introduction

Banks are in the business o f lending and b o r r o w i n g m o n e y . M e r c e r (1992)

reports that earnings f r o m the margin, or spread, b e t w e e n interest rates on assets
and interest rates on liabilities typically account for 80 percent or m o r e o f bank

* Tel.: (852) 2859-1044; fax: (852) 2548-1152; e-mail: kpwong@econ.hku.hk.

0378-4266/97/$17.00 Copyright © 1997 Elsevier Science B.V. All rights reserved.

PII S037 8-4266(96)00037-4
252 K.P. Wong / Journal of Banking & Finance 21 (1997) 251-271

profits. 1 As the spread is so important to bank profitability, the issues of how it is

optimally determined and how it adjusts to changes in the banking environment
deserve closer scrutiny.
In practice, spread management is done through a 'cost of goods sold' approach
in which deposits are the 'material' and loans are the 'work in process' (see Finn
and Frederick, 1992). The purpose of this paper is to follow this approach by
providing a firm-theoretical model of bank behavior to study the determination of
optimal bank interest margins. Our model features a risk-averse bank facing both
credit risk and interest rate risk. Credit risk is present because loans are subject to
non-performance and the bank does not know ex ante what proportion of its loans
will perform. Interest rate risk arises because the bank funds part of its fixed rate
loans via variable rate deposits (i.e., there is a mismatching of rate sensitivities of
assets and liabilities). The bank also has access to the interbank market (e.g., the
Fed funds market) where it can purchase or sell additional funds. A capital
adequacy requirement is imposed upon the bank such that a minimum capital-to-
deposits ratio has to be met by the bank.
The results of this paper show how cost, regulation, credit risk and interest rate
risk conditions jointly determine the optimal bank interest margin. We find that the
optimal bank interest margin is larger when the bank is risk averse than when the
bank is risk neutral. Further, the spread widens as the bank's degree of risk
aversion rises. With reasonable assumptions about the bank's underlying prefer-
ence, a number of interesting comparative statics are derived. 2 We show that the
optimal bank interest margin reacts positively to an increase in market power, an
increase in operating expenses, an increase in credit risk, or an increase in interest
rate risk. However, an increase in the interbank market rate (e.g., the Fed funds
rate) has a disparate effect on the optimal bank interest margin depending on
whether the bank is a net borrower (positive effect) or a net lender (ambiguous
effect) in the interbank market. Further, we show that an increase in the bank's
equity capital has a negative effect on the spread when interest rate risk is absent
or at least not severe. Otherwise, the effect is ambiguous. Our results are largely

i Bank interest margin, or net interest margin as it is commonly called, is usually defined as the
difference between interest revenue and interest expense expressed as percentage of average earning
assets. Spread, on the other hand, is the difference between the yield rate on average interest earning
assets and the cost rate on interest bearing funds, with both elements expressed in percentage terms.
Olson and Simonson (1982) show that bank interest margin and spread need not be identical unless
there are zero noninterest bearing funds. We are a bit informal here and use these two terms
synonymously.
2 Since we ponder over a situation with multiple sources of risk (both credit risk and interest rate
risk), the usual Arrow-Pratt theory of risk behavior may be too weak to yield intuitive results. As will
be shown below, two stronger notions of risk behavior, namely, the Ross (1981) characterization of
decreasing absolute risk aversion and the Kimball (1993) standard risk aversion, are needed to resolve
certain ambiguous results.
 K.P. Wong / Journal of Banking & Finance 21 (1997) 251-271 253

supported by the empirical evidence of Ho and Saunders (1981), McShane and

Sharpe (1985) and Angbazo (1995) concerning bank spread behavior.
The prevailing approach to analysing bank interest margins has been the
dealership model originated by Ho and Saunders (1981). In this model, banks are
viewed as risk-averse dealers in loan and deposit markets where loan requests and
deposit funds arrive nonsynchronously at random time intervals. Bank interest
margins are shown to be fees charged by banks for the provision of liquidity. This
model is further extended to account for cross-elasticities of demand between bank
products (Allen, 1988) and for default risk (Angbazo, 1995). Notwithstanding the
alternative finn-theoretical approach being used, our model yields much the same
implications as the dealership model. In this regard, our model should be viewed
as confirmation of rather than confrontation with the existing literature.
Zarrnk (1989) and Zarruk and Madura (1992) also provide finn-theoretical
models to explain bank spread behavior. 3 A notable difference between our model
and theirs is that they look at situations with only a single source of uncertainty:
funding risk as in Zarruk (1989) and credit risk as in Zarruk and Madura (1992).
With the richer risk structure in our model, we are able to derive more results
which are supported by empirical evidence. For example, Zarrnk (1989) shows
that an increase in operating expenses has an ambiguous effect on optimal bank
interest margins and that larger banks have wider spreads if the underlying
preferences of banks exhibit the reasonable property of decreasing absolute risk
aversion in the Arrow-Pratt sense. These theoretical findings are in sharp contrast
to the Ho and Saunders (1981) empirical findings that bank interest margins are
positively related to operating expenses and inversely related to bank size. We, on
the other hand, are able to examine the effect of greater interest rate risk which is
present neither in Zarruk (1989) nor in Zarruk and Madura (1992).
The remaining parts of this paper are organized as follows. Section 2 lays out
the basic model of a banking finn under risk aversion and multiple sources of
uncertainty. Section 3 characterizes the optimal bank interest margin with a
comparison between the risk-averse spread and the risk-neutral spread. Section 4
develops the comparative static properties of the model. Section 5 examines the
robustness of our results upon introducing incentive problems h la Stiglitz and
Weiss (1981) among borrowers. The final section concludes the paper.

3 In Zarruk and Madura (1992), there is an analytical mistake which invalidates their results. Zarruk
and Madura model loan defaults by a random variable lying between zero and the total amount of loans
granted by a bank. The total amount of loans, on the other hand, is a function of the loan rate. This
implies that the support of random loan defaults moves as the bank changes its loan rate. Zarruk and
Madura overlook this moving support factor and thus fail to obtain the correct first-order condition.
When this factor is taken into consideration, none of the comparative statics considered by Zarruk and
Mudura are determinate.
254 K.P. Wong/ Journal of Banking & Finance 21 (1997) 251-271

2. T h e m o d e l

Consider a risk-averse bank which makes decisions in a single-period horizon.

At the beginning of the period, the bank has the following balance sheet:

L+B=D+K, (1)

where L is the amount of loans, D is the quantity of deposits, K is the stock of

equity capital, and B is a composite variable denoting the bank's net position in
the interbank market. If B > ( < ) 0 , the bank lends (borrows) in the interbank
market at a known one-plus rate, R. The equity capital of the bank, K, is assumed
to be fixed over the planning horizon, although it has to satisfy the following
capital adequacy requirement by regulation:

K >_ KD, (2)

where K is the required minimum capital-to-deposits ratio. 4

Loans granted by the bank belong to a single homogeneous class of fixed-rate
claims with one-period maturity. The loan market is imperfect in the sense that the
bank is a loan-rate setter. 5 The demand of loans is specified by a downward-slop-
ing function, L(RL), where R L is the one-plus loan rate and E < 0. Loans are
risky because they are subject to non-performance. Following Taggart and Green-
baum (1978), we model this credit risk by means of a random variable 0, with
support [0, 1], to denote the proportion of non-performing loans at the end of the
period. 6 Without loss of generality, we assume that non-performing loans pay
nothing to the bank. The actual value of loan repayments to the bank is therefore
(1 - O)RLL(RL), which is less than or equal to the value of the total contractual
loan repayments, RLL(RL), depending on the realization of 0 at the end of the
period. As in Taggart and Greenbaum (1978), we assume that the distribution of/9
is unaffected by the level of lending so that the degree of uncertainty per dollar of
loans is constant. To wit, we assume away any adverse selection a n d / o r moral
hazard problems h la Sfiglitz and Weiss (1981) that the bank might confront in
setting its loan rate. This assumption will be relaxed in Section 5.
Deposits issued by the bank have a maturity shorter than one period so that they
must be rolled over at the then-prevailing unknown one-plus deposit rate, /~o. The
bank is a quantity setter in the deposit market where the supply of deposits is
perfectly elastic. As the bank funds fixed-rate loans via variable-rate deposits, it

4 The required minimum capital-to-deposits ratio can be made risk-based as in Zarruk and Madura
(1992) (i.e., K is an increasing function of L). Adding this complexity affects none of the qualitative
results.
5 Loan-rate setting behavior by banks is well documented by Stovin and Sushka (1983) and Hancock
(1986).
6 Throughout the paper, a tilde ( ~ ) always signifies a random variable.
 K.P. Wong/ Journal of Banking & Finance21 (1997)251-271 255

u n a v o i d a b l y exposes itself to interest rate risk. 7 W e adopt the usual assumption of

a positive relationship b e t w e e n loan defaults and the deposit rate. 8 In our
f r a m e w o r k , this is e q u i v a l e n t to assuming that 0 and R o are positively correlated.
T o m a k e things tractable, we assume that the relationship b e t w e e n 0 and /~o is
specified by the f o l l o w i n g nonlinear regression model: 9

RD = R o ( 0 ) + ~, (3)

where ~ is a z e r o - m e a n r a n d o m variable independent o f 0, and Ro(O) is the

e x p e c t e d deposit rate conditional upon 0 = 0. The positive correlation b e t w e e n
and /~o is established by assuming that R'o(O)> 0 for all 0 ~ [0, 1]. 10 This
captures the intuitive notion that a larger realization of 0 is a c c o m p a n i e d by a
higher e x p e c t e d deposit rate should these two r a n d o m variables be positively
correlated.
The b a n k ' s r a n d o m e n d - o f - p e r i o d profit is g i v e n by

~- = (1 - 0 ) RLL ( RL) + RB - R o D - CL( RL), (4)

where C is the constant marginal administrative cost o f loans. 11 U s i n g the

balance sheet identity (1) and assuming that the capital r e q u i r e m e n t constraint (2)
is binding, Eq. (4) can be stated as 12

[(1- L(R ) + Rx + (5)

w h e r e D = K / K is the m a x i m u m a m o u n t o f deposits issued by the bank.
Let U(Tr) be the v o n N e u m a n n - M o r g e n s t e m utility function of the bank
defined o v e r the b a n k ' s e n d - o f - p e r i o d profit, 7r. U is assumed to be thrice
continuously differentiable with U ' > 0 and U" < 0 (i.e., the bank is risk averse).

7 The bank can in principle hedge against interest rate risk through the trading of interest rate
futures. The existence of basis risk in futures markets prevents a perfect hedge, and thus some interest
rate risk is always present.
8 Sealey (1980) argues that this assumption "can be justified on the basis of business cycle
movements in loan defaults and deposits" (p. 1145).
9 Using the technique introduced by Wong (1996), most of our qualitative results are unaffected if
we replace the nonlinear regression model by a more general dependence structure of 0 and Ro known
as regression dependence.
10 It is easy to show that the correlation between 0 and Ro is positive given (3) and R'o > 0. The
two random variables are independent only when Ro(O) is invariant to all 0 ~ [0, 1]. In fact, R'o >_0
is more than necessary for our qualitative results. What we really need is for R'o > - RLL(RL)/D at
the optimal loan rate. That is, as long as RD and 0 are not too negatively correlated, all of our
qualitative results remain intact.
II The marginal administrative cost of deposits and the fixed costs are omitted for simplicity because
they will have the same qualitative effect on the optimal bank interest margin as the marginal
administrative cost of loans.
12 The capital requirement constraint will be binding as long as the interbank market rate is
sufficiently higher than the expected deposit rate.
256 K.P. Wong/ Journal of Banking & Finance21 (1997)251-271

Before any uncertainty is resolved, the bank chooses its loan rate, RL, SO as to
maximize the expected utility of its end-of-period profit:

maxE[U(#)] = f l f ' : u [ q ' r ( O, e ) ] d F ( 0 ) d G ( e ) , (6)

RL "0"%1
where 7r(0, e) is the realization of ~" defined in Eq. (5) at (0, ~) = (0, e), and
F:[0, 1] ---) [0, 1] and G:[e 1, e 2 ] ---) [0, 1] are the cumulative distribution functions
(CDFs) of ff and ~, respectively.

3. The o p t i m a l b a n k interest m a r g i n

The first-order condition for an optimum of program 6 is 13

OE[U(~'*)] E[U,(~,)M(~)]E(RL)=O ' (7)

ORL
where R L is the optimal loan rate, ~- is Eq, (5) evaluated at R L, 7/ =
- L ( R ~ )/R~ E(R~ ) is the reciprocal of the interest rate elasticity of loan demand
evaluated at R~, and
M(O) = (1 - 0 ) ( l - ~7*)R L - R - C.
Note that M(1) = - R - C < 0, M(0) = (1 - 7 7 * )R r*- R - C a n d M'(0)=-(1
- 7/* )R L *. Inspection of Eq. (7) reveals that a necessary condition for an interior
value of R~ is that M(0) > 0, which in turn implies that ~/* < 1. That is, the bank
will operate on the elastic portion of its loan demand curve, just as a monopolistic
firm would do.

3.1. Risk-averse versus risk-neutral bank interest margins

Theoptimal bank interest margin is defined as R~ - RD, where RD = E(RD).

Since R D is not a choice variable of the bank, the properties of the optimal bank
interest margin are the same as those of the optimal loan rate.
It is of interest to compare the optimal bank interest margin under risk aversion
with that under risk neutrality. In the risk-neutral case, U' is a constant and thus
the first-order condition (7) becomes
( 1 - -O) ( 1 - nn)R'] - R - C=O, (8)

13The second-order condition for a maximum of (6) is

02E[U(~r *)]
E[U"(~")M(0) 2] E ( R ; ) 2 + E [ U ' ( ~ r * ) ( 1 - 0 ) ] [ 2 E ( R ; ) + ~ * R ; E ' ( R ; ) ]
0R~
<0,
where we have applied (7) to simplify the expression. Since the support of 0 is in [0, 1], a sufficient
(but not necessary) condition to guarantee the above second-ordercondition is that E' < 0.
 K.P. Wong/ Journal of Banking & Finance 21 (1997) 251-271 257

where 0 = E(0), R E is the optimal risk-netural loan rate, and ~/n is the reciprocal
of the interest rate elasticity of loan demand evaluated at R~. Condition (8)
implies that the bank sets its optimal loan rate, R E, at the point where the expected
marginal profit of loans, (1 - 0)(1 - ~/n)R~ - C, equals the interbank market rate,
R, which is a well-known result by Klein (1971) for risk-neutral banks.
On the other hand, under risk aversion (i.e., U" < 0), we have 14
E[U'(qr*)lO] >(<)E[U'(qr*)[O] for 0>(<)5, (9)
where E(.[0) is the expectation operator with respect to G conditional upon
= 0. Since M' < 0, multiplying M(O) - M(O) to both sides of inequality 9 and
taking expectations with respect to F yields

)101 [ M ( 0 ) - M(0)] =0,

(lO)
since E [ M ( 0 ) ] = M(0). Using Eqs. (7) and (10), we know that
M ( 0 ) = (1 - 0 ) ( 1 - r / * ) R ; - R - C>0. (11)
Condition (11) implies that the bank sets its optimal loan rate, R~, at the point
where the expected marginal profit of loans, (1 - 5)(1 - ~ * )R~ - C, exceeds the
interbank market rate, R. Comparing conditions 8 and 11 and using the second-
order condition of the risk-neutral case, we have R~ > R E. This result is intuitive
because the bank can lend in both the loan and the interbank markets. As loans are
subject to non-performance, a risk premium is charged on the loans to compensate
for bearing credit risk should the bank be risk averse, is To summarize, we have
the following proposition.

Proposition 1. The optimal bank interest margin is larger when the bank is risk
averse than when the bank is risk neutral.

3.2. Increases in risk aversion

A related question is to consider the impact of an increase in the bank's degree

of risk aversion on its spread decision. As is well known in the literature, with
multiple sources of risk, the Arrow-Pratt theory of risk aversion is usually too
weak to yield intuitively appealing results. To resolve this problem, we adopt a
stronger notion of risk aversion advocated by Ross (1981).

14Note that partially differentiating E[U'(~r *)10] with respect to 0 yields

0Z[U'(~* )10]
E[U"(~ *)I0][R~ L(R~ ) + RS(0)D] > 0,
where the inequality follows from U" < 0 and R~ > 0.
15ZalTuk (1989) and Zarruk and Madura (1992) reach the same result that the risk-averse spread is
higher than the risk-neutral spread in cases with a single source of uncertainty.
258 K.P. Wong / Journal of Banking & Finance 21 (1997) 251-271

According to Ross, utility function V is strongly more risk averse than utility
function U if, and only if, there is a positive constant A such that
V"(~) V'(~2)
- - > A > - - for allTr 1 andzr 2. (12)
Vtt(q./.1) -- __ U t ( , . B . 2 )

Simply rearranging definition (12) reveals that V is more risk averse than U in
the Arrow-Pratt sense. Ross provides an example to show that the converse is not
true and thus definition 12 does indeed produce a strictly stronger ordering than
the Arrow-Pratt one. Ross further shows that definition 12 is equivalent to
V(~) = AU(~) + / 4 ( ~ ) , (13)
where H is a positive function with H ' < 0 and H" < O. Directly comparing the
optimal bank interest margin under V with that under U yields the following
proposition.

Proposition 2. The optimal bank interest margin increases as the bank becomes
stongly more risk averse in Ross' sense.

Proof See the appendix. []

Proposition 2 is supported by the empirical findings of McShane and Sharpe

(1985) that there is a positive relationship between bank interest margins and the
degree of absolute risk aversion for Australian banks. This result will prove to be
useful in interpreting the comparative statics in the next section.

4. Comparative statics of the model

Having examined the solution to the bank's optimization problem, in this

section we consider the effects on the optimal loan rate (and thus the optimal bank
interest margin) from changes in the parameters of the model.

4.1. Increases in market power

Denote , / = - L ( R L ) / R L E ( R L) as the reciprocal of the interest rate elasticity

of loan demand at the loan rate R L. Since r / i s proportional to the Lemer index of
the bank, 7/ is a measure of the bank's market power. 16 If a bank faces a loan
demand curve which has the reciprocal of the interest rate elasticity everywhere
larger than that of another bank, we can unambiguously conclude that the former
bank possesses greater market power than the latter bank. This suggests a way to
study the effect of market power on the optimal bank interest margin.

16 See Tirole (1988, p. 66).

 K.P. Wong/ Journal of Banking & Finance21 (1997)251-271 259

Suppose that we replace the loan demand function L(R L) with

L(RL) = (1 -- m) L(RL) + mL( R L ),
where m is a shift parameter taking an initial value of zero. Note first that the
market size of the bank at R~ is invariant to a change in m (a ceteris paribus
^ - R L ). Denote 7/= - L( R L) / R LE ( R L). Different i at -
assumption) since L( R L ) = L( * ^ ^ "~' "

ing 0 with respect to m and evaluating at m = 0 yields

OO re=O--
Om
L(RL) >0.
RLE(RL)
That is, an increase in m increases the reciprocal of the interest rate elasticity of
loan demand at all loan rates. Thus, m can be viewed as a market power shift
parameter which keeps the market size of the bank constant at R L . We refer to an
increase in m as a size-preserving increase in market power of the bank.
Implicitly differentiating Eq. (7) with respect to m and evaluating at m = 0
yields

dRLdm m=0= E [ U ' ( ~ * ) ( 1 - A 0 ) ] n * R L E ( R L ) , (14)

where A = 02E[U(# * )]/ORZL is negative by the second-order condition. Since

is in [0, 1], the right-hand side of Eq. (14) is positive and the following proposition
is established.

Proposition 3. A size-preserving increase in the bank's market power increases

the optimal bank interest margin.

McShane and Sharpe (1985) report a positive relationship between market

power and spreads for Australian banks. Thus, Proposition 3 provides an alterna-
tive explanation for this empirical observation.

4.2. Increases in marginal administrative cost of loans

Implicit differentiation of Eq. (7) with respect to C yields

dR Z E[U'(~*)]E(R~) E[U"(~*)M(O)]L(RL)E(R~)
- +

dC A A
(15)
The first term on the right-hand side of Eq. (15) can be interpreted as the
substitution effect, while the second term can be interpreted as the income
effect. 17

~7The decompositionof (15) into the substitution effect and the income effect can be formally done
via the method of compensation proposed by Davis (1989).
260 K.P. Wong/ Journal of Banking & Finance 21 (1997) 251-271

The substitution effect captures the change in R~ due to an increase in C,

holding the expected utility constant. It is unambiguously positive because an
increase in C makes loans more costly to grant. In response to this, the bank has
an incentive to reduce the amount of loans it grants by charging a higher loan rate,
ceteris paribus.
The income effect arises because a one dollar increase in C decreases the
bank's profit by L(R~ ) in every possible state. As usual, the sign of this income
effect is indeterminate. However, Proposition 2 provides us with a hunch that the
income effect will be positive should the bank's utility function exhibit decreasing
absolute risk aversion (DARA) in Ross' sense. The rationale is that as operating
costs increase, income declines and with DARA the bank becomes more risk
averse and thus is unwilling to take on greater risk. As a result, the bank raises its
loan rate to cut risky lending.
The above conjecture is formally proved in the appendix where we have shown
that E[U"(~-)* )M(0)] > 0 under DARA in Ross' sense. Since the income effect
reinforces the substitution effect to give an overall positive response of R~ to an
increase in C, we establish the following proposition.

Proposition 4. I f the bank's utility function exhibits DARA in Ross' sense, then
an increase in the marginal administrative cost of loans will increase the optimal
bank interest margin.

Proposition 4 reveals that the bank passes the burden of rising operating
expenses to borrowers by widening the bank interest margin. This result is
consistent with the empirical findings of Ho and Saunders (1981) that actual bank
interest margins are positively related to operating costs.

4.3. Increases in interbank market rate

Implicit differentiation of Eq. (7) with respect to R yields

dR~ E[U'(~'*)]E(RL) E[U"('Tr*)M(O)]B*E(RL)

dR A A (16)
where B * = D + K - L(R~ ) is the bank's net position in the interbank market.
The first term on the right-hand side of Eq. (16) can be identified as the
substitution effect. An increase in R makes lending in the loan market less
attractive relative to that in the interbank market. This induces the bank to invest
less in loans by charging a higher loan rate, ceteris paribus. The substitution effect
is therefore unambiguously positive.
The income effect is captured by the second term on the right-hand side of Eq.
(16). If the bank is a net borrower in the interbank market (i.e., B * < 0), the
bank's profit drops as R rises. With DARA, the bank is less eager to take risk and
 K.P. Wong/ Journal of Banking & Finance21 (1997)251-271 261

thus it charges a higher loan rate to reduce lending. The income effect in this case
is therefore positive and reinforces the substitution effect. This implies that a net
borrower in the interbank market should raise its loan rate in response to an
increase in the interbank market rate. On the other hand, if the bank is a net lender
in the interbank market (i.e., B * > 0), the income effect becomes negative and
works against the substitution effect. This makes the total effect on R~ indetermi-
nate. To summarize, we have the following proposition.

Proposition 5. If the bank's utility function exhibits DARA in Ross' sense, then
the effect of an increase in the interbank market rate on the optimal bank interest
margin is either positive or ambiguous depending on whether the bank is a net
borrower or a net lender in the interbank market, respectively.

Ho and Saunders (1981) find that the relationship between the interbank market
rate and the actual bank interest margins is not statistically different from zero for
their full sample, which does not distinguish between banks according to their net
positions in the interbank market. Proposition 5 is consistent with this empirical
observation. Furthermore, according to Allen et al. (1989), large money-center
banks appear to be net Fed funds purchasers while smaller banks tend to be net
Fed funds sellers. An indirect implication of Proposition 5 is that large banks
should react positively to an increase in the interbank market rate, whereas small
banks' reactions are not known a priori.

4.4. Increases in credit risk

To study the effect of an increase in credit risk, we follow Sandmo (1971) by

replacing 0 with sO+ ( 1 - s)0, where s is a mean-preserving shift parameter
with an initial value of one. The impact of a mean-preserving increase in credit
risk is found by implicitly differentiating Eq. (7) with respect to s and evaluating
at s = l :

dR;ds s=l = E[U'('7r* ) ( O - O ) ] ( 1 - ~* ) R ; E( R;

E[U"(~-*)M(0)(0- 0)]R;L(RZ)E(R;)
+ A (17)

The first term on the right-hand side of Eq. (17) is the substitution effect which
is unambiguously positive. To see this, note that
( 0 - 0)(1 - n ) R L = M ( 0 ) - M(0). (18)
Using this and Eq. (7), the first term on the right-hand side of Eq. (17) becomes
E[ U'('~" * )] M ( O ) E ( R L )
>0,
A
262 K.P. Wong/ Journalof Banking & Finance21 (1997)251-271

where the inequality follows from condition 11. Roughly, the substitution effect
arises because greater credit risk increases the relative riskiness of loans vis-h-vis
lending in the interbank market, prodding the bank to steer away from issuing
risky loans even when compensated to remain at an unchanged level of expected
utility.
The second term on the right-hand side of Eq. (17) is the income effect which
is also positive given DARA in Ross' sense. To see this, rewrite the term using
Eq. (18) to yield
E[U"( ~r*)M( O)]M('O)L( R~ ) E ( R; )
( 1 - 'r/* ) d

E l U"(~'* ) M ( ~)2] L( R L ) E ( R; )
- >0,
(1--~*)A
where the inequality follows from E[U"(~r)*)M(O})] > 0 and condition 11. The
income effect arises because greater credit risk reduces the attainable expected
utility under risk aversion; at the greater level of risk, the bank has to be
compensated with additional income to attain the former (lower level of risk)
expected utility level. Taking away the compensation gives rise to the income
effect. With DARA, the sign of this income effect is not surprisingly positive.
As the income effect reinforces the substitution effect, the total effect of a
mean-preserving increase in credit risk on the optimal bank interest margin is
unambiguously positive, which is consistent with the empircal findings of Angbazo
(1995). 18

Proposition 6. If the bank's utility function exhibits DARA in Ross' sense, then a
mean-preserving increase in credit risk will increase the optimal bank interest
margin.
4.5. Increases in interest rate risk

Following Sandmo (1971), we model a mean-preserving increase in interest

rate risk by replacing ~ with o.~, where o. is a mean-preserving shift parameter
taking an initial value of one. Implicitly differentiating Eq. (7) with respect to o.
and evaluating at o. = 1 yields
dR~ ,7= = E[U"(,Tr* )M( O)~]DE( R~ ) (19)
do- 1 Z~

As the capital adequacy requirement is assumed to be binding, interest rate risk

is exogenous in our model and thus substitution effect is absent. The right-hand

18HOand Saunters (1981) also documenta positiverelationshipbetweencreditrisk and bank interest

margins. However,their results are not statisticallysignificant.
 K.P. Wong/ Journal of Banking & Finance 21 (1997) 251-271 263

side of Eq. (19) represents the income effect. Unfortunately, D A R A in Ross' sense
fails to ensure its sign. To get a concrete result, we use an additional strong yet
canonical notion of risk behavior.
Recently, Kimball (1993) has introduced the theory of standard risk aversion to
deal with situations of multiple risk bearing. He defines 'prudence' as U" > 0 and
the precautionary premium ~b as the quantity satisfying
U ' [ T r - ~0(~, #r)] = E [ U ' ( ~ - + ~)],
where ~ is a noise term. 19 He shows that $ is proportional to the index
- U ' ( ~ ) / U " ( T r ) , which he denotes as the degree of absolute prudence. A utility
function is said to have standard risk aversion if " e v e r y risk that has a negative
interaction with a small reduction in wealth also has a negative interaction with
any undesirable, independent r i s k " (see Kimball, 1993, p. 589), where "negative
interaction" denotes a utility loss. Kimball shows that this condition holds if, and
only if, the utility function exhibits both D A R A in the A r r o w - p r a t t sense and
decreasing absolute prudence (DAP).
Equipped with the concept of standard risk aversion, we show in the following
proposition that the effect of a mean-preserving increase in interest rate risk on the
optimal bank interest margin is unambiguously positive.

Proposition 7. If the bank's utility function exhibits DARA in Ross' sense and
standard risk aversion, then a mean-preserving increase in interest rate risk will
increase the optimal bank interest margin.

Proof. See the appendix. []

Ho and Saunders (1981), McShane and Sharpe (1985) and Angbazo (1995) all
find empirical evidence that bank interest margins are positively related to the
degree of interest rate risk. Thus, their findings lend support to Proposition 7.20

4.6. Increases in equity capital

Implicit differentiation of Eq. (7) with respect to K yields

dK KA

19In essence, ~b is analogous to Pratt's risk premium, but for U' rather than U.
2o The effect of increases in the correlation between credit risk and interest rate risk on the optimal
spread is not reported in the paper because it is a priori indeterminate. The reason is that an increase in
this correlation, say, through a multiplicative shift parameter attached to the function RD(O), will
increase the interest rate risk at the same time. To restore the variance of /~o, we have to reduce the
magnitude of ~. An increase in RD(O)reduces the bank's profit and thus, with DARA, the bank has an
incentive to raise its loan rate. However, by Proposition 7, a decrease in ~ (so as to keep the variance
of /~o fixed) induces the bank to lower its loan rate. These two forces work against each other and
make the overall impact indeterminate.
264 K.P. Wong/Journal of Banking & Finance21 (1997)251-271

The right-hand side of Eq. (20) is the income effect which can be further
decomposed into two parts:

dR; _ E [ U " ( ~ * ) M ( O)][ ff, D - ( I + K ) R ] E ( RL )

dK KA

+ KA (21)

The first term on the right-hand side of Eq. (21) is negative given D A R A in
Ross' sense since Ro < R for the capital requirement constraint (2) to be binding.
In the absence of interest rate risk (i.e., /~o = RD), a one dollar increase in equity
capital increases the bank's profit by R + (Ro - R ) / K in all possible states. With
DARA, the bank becomes less risk averse and thus is willing to grant more risky
loans by lowering the loan rate. However, the second term on the right-hand side
of Eq. (21) is likely to be positive and thus works against the first term. 21 This
countervailing force arises because the enlarged capital base allows the bank to
issue more variable rate deposits while still satisfying the capital adequacy
requirement. This increases the variability of the bank's profit which in turn
induces the bank to take on less risky loans by raising the loan rate. Hence, the
aggregate income effect is a priori indeterminate unless interest rate risk is not a
significant factor for the bank spread decision. To summarize, we establish the
following proposition.

Proposition 8. If the bank's utility function exhibits DARA in Ross' sense and if
the interest rate risk is not severe, then an increase in the bank's equity capital
will decrease the optimal bank interest margin. Otherwise, the effect is ambiguous.

Proof See the appendix. []

Ho and Saunders (1981) find that interest margins of small and large banks are
significantly different with the average spread of small banks approximately
one-third of one percent more than that of large banks. Ho and Saunders attribute
this difference to the fact that small banks are usually more regionally oriented and
thus possess greater market power as compared to large money-center banks. 22
Proposition 8 says that even if the market power factor is controlled for, a large
bank is likely to have a narrower spread as long as the bank can hedge away most
of the interest rate risk.

21 The second term on the right-hand side of (21) is positive, say, when Ro(O) is linear in 0. See the
appendix.
22This reasoning is consistent with Proposition 3.
 K.P. Wong/ Journal of Banking & Finance 21 (1997) 251-271 265

5. Effects of incentive problems on bank interest margins

We have assumed hitherto that credit risk is independent of the loan rate
charged by the bank. As argued by Stiglitz and Weiss (1981), this is a rather
strong assumption when incentive problems either in the form of adverse selection
or in the form of moral hazard are present in the loan market. With adverse
selection, an increase in the loan rate is likely to attract only higher risk borrowers
who preceive a lower probability of repaying the loan. It is because these
borrowers are less affected by the higher interest rate as compared to credit-worthy
borrowers. This implies that the average 'riskiness' of those who borrow increases
with an increase in the loan rate. Similarly, with moral hazard, the behavior of
borrowers is likely to change as the loan rate changes. For instance, a higher loan
rate induces firms to undertake projects with lower probability of success but
higher payoffs when successful. This again implies that credit risk increases with
an increase in the loan rate.
To model the incentive problems h la Stiglitz and Weiss (1981) into our
framework, we assume that the CDF of 0 shifts in the sense of first-order
stochastic dominance as the loan rate changes. Specifically, we consider a family
of CDFs of 0 indexed by R L, {/~(.[RL)}, such that

< 0, (22)
OR L

for all 0 ~ [0, 1]. Condition (22) says that an increase in R L increases the
likelihood that higher values of 0 will be realized and thus gives rise to a
deterioration in borrowers' credit-worthiness.
Replacing F with /~(. IRL), the first-order condition (7) can be written as
oE[u( * *)l
OR L

+ f of ,. ,. . . . . . L(R )

OP(OIRi *)
+ O) O] dOd ( ) = 0, (23)
OR L

where we use the integration-by-parts formula, R~ * is the optimal loan rate in

• * ** * * *
this case, ~* * is Eq. (5) evaluated at R L , and T/ = - L ( R ~ ) / R ~ E ( R ~ )
is the reciprocal of the interest rate elasticity of loan demand evaluated at R~ *.
Clearly, the second term on the left-hand side of Eq. (23) is negative given
condition 22 and that R'o > 0. Hence, if we evaluate the left-hand side of Eq. (23)
266 K.P. Wong/Journal of Banking & Finance21 (1997)251-271

at R~ and assume that F(O)= F(OIR~ ) (a ceteris paribus assumption), then the
first term on the left-hand side of Eq. (23) vanishes by Eq. (7). This implies that
0E[U(~" *)]/aR r < 0 . Thus, we have R~ * <R~ which follows from the
second-order condition of the new maximization problem taking the incentive
problems into account.

Proposition 9. Other things being equal, an introduction of incentive problems

among borrowers lowers the optimal bank interest margin.

The intuition underlying Proposition 9 should be clear. The presence of the

incentive problems in the loan market penalizes any aggressive loan pricing
behavior of the bank. As a result, the bank lowers its loan rate in order to partially
insulate itself from the opportunistic behavior of the borrowers.
Comparing Eq. (7) and Eq. (23), we immediately notice that when the incentive
problems are present the comparative statics may differ from those considered in
Section 4 simply because of the second term on the left-hand side of Eq. (23).
Whenever the bank's profit increases by one dollar in all possible states, this
additional term of Eq. (23) moves the optimal loan rate upward by an amount
1
Z] *(0,,)] [R;* R~

OP(OIR~ *)
+ R ' o ( 0 ) D] d 0 d G ( , ) > 0, (24)
ORL
where z~ = 0 2 E [ U ( ~ * * )]/OR 2 < 0 by the second-order condition. Thus, condi-
tion 24 creates a countervailing force which works against the original income
effect (given DARA in Ross' sense). However, as long as the incentive problems
are not severe in the sense that OF(OIRL)/OR L is small, we should expect the
comparative static results of the previous section to remain intact under imperfect
information.

6. Conclusions

In this paper, we have developed a simple firm-theoretical model to study the

optimal bank interest margin (i.e., the spread between the loan rate and the deposit
rate) of a risk-averse bank facing both credit and interest rate risks. We utilize the
model to show how cost, regulation, credit risk and interest rate risk conditions
jointly determine the optimal spread decision. Specifically, we find that the
optimal bank interest margin is positively related to the bank's market power, to
the operating costs, to the degree of interest rate risk, and to the degree of credit
risk. However, the effect of changes in the interbank market rate (e.g., the Fed
 K.P. Wong / Journal of Banking & Finance 21 (1997) 251-271 267

funds rate) on the optimal spread is ambiguous and depends on the bank's net
position in the interbank market. Furthermore, the bank's equity capital is nega-
tively related to the spread when interest rate risk is trivial. These results are
largely supported by the empirical evidence of Ho and Saunders (1981), McShane
and Sharpe (1985) and Angbazo (1995) concerning bank spread behavior.

Acknowledgements

This paper is based on Chapter 4 of Wong (1993). I am indebted to Ron

Giammarino (my thesis advisor) for his patient advice and encouragement. I also
gratefully acknowledge the comments of Paul Fischer, Helena Mullins, Sheridan
Titman, Josef Zechner, two anonymous referees, and seminar participants at the
University of British Columbia and the Hong Kong University of Science and
Technology. Any remaining errors are mine.

Appendix A. Proofs

A. 1. Proofof Proposition 2

Let V be the bank's new utility function. Then, V can be represented as Eq.
(13). Evaluating the first partial derivative of E[V(#)] with respect to R L at R L ,
we get
OE[V(~*)]
ORL =E{[AU'(~r*)+H'('7r*)IM(O)E(R;)

where the second equality follows from Eq. (7).

Define J(O)= E[H'(~r*)I0], where E(-I0) is the expectation operator with
respect to G conditional upon 0 = 0. Differentiating J with respect to 0 yields
J'( O) = -E[ H"(5 *)IOI[ RI L( Ri ) + R'~( O)D] >__0,
where the inequality follows from R D > 0 and H" < 0. Thus, we have

J(O)>(<)J(O) for 0>(<)3, (A.1)

where 0 solves M(O) = O. Multiplying M(O)E(R~ ) to both sides of inequality
A.1 and taking expectations with respect to F, we obtain

E[ H'( ~r* )M( O)]E( RL ) > J( O)M(-O)E( R; ) >0,

 268 K.P. Wong/Journal of Banking & Finance21 (1997)251-271

where the second inequality follows from J < 0, E < 0 and condition 11. The
desired result then follows directly from the first- and second-order conditions
under V. []

A.2. Proof of EIU"(~r * )M(O)] > 0 under DARA in Ross' sense

According to Ross (1981), U exhibits DARA in Ross' sense if, and only if,
there exists a positive constant y such that

- - > 3' >-

- for all ~-. (A.2)

Define N ( O ) = E[U"(#*)IO]/E[U'(~r*)[O], where E(.I0) is the expectation op-

erator with respect to G conditional upon 0 = 0. Differentiating N with respect to
0 yields

R ; L ( R ; ) + R'D( O)D E[U"(#*)I0] 2 }

N'(O) = -
E[U'(~-*)I0] T[v ;3 "

(A.3)
By DARA in Ross' sense, condition A.2, we have
V " [ ~ * (0, ~)]
>Y. (A.4)

Multiplying -U"[zr *(0, E)] to both sides of inequality A.4 and taking expecta-
tions with respect to G yields
E[U"(~r*)fO] > - T E [ U " ( ~ r * ) I O ] . (A.5)
Again, from condition A.2, U exhibits DARA in Ross' sense implying that
V"[~* (0, , ) ]
- U ' [ T r * ( 0 , , ) ] -<Y" (A.6)
Multiplying -U'[zr*(O,e)]/E[U'(~r*)rO] to both sides of inequality A.6 and
taking expectations with respect to G yields
E[U"(~*)I0]
- E[U'(~*)]0] < y" (A.7)

Hence inequalities A.5 and A.7 imply that

Z[V"(~*)lO] 2
E[u"(~*)lo] >__ E [ v ' ( ~ * ) l o ] " (A.8)
Thus, (A.3) and (A.8) imply that N' < 0.
Since N' < 0, we have
N(O)<(>_)N(O) for O>(<)0, (A.9)
 K.P. Wong/ Journal of Banking & Finance 21 (1997) 251-271 269

where 0 solves M(/~)=0. Multiplying both sides of inequality A.9 by

E[U'(~r * )[ 0 ]M(0) and taking expectations with respect to F yields

where the equality follows from Eq. (7). []

A.3. Proof of Proposition 7

Define Z(O)= E[U"(~-*)glO]/E[U'(~r*)[O], where E(.I0) is the expectation
operator with respect to G conditional upon 0 = 0. Differentiating Z with respect
to 0 yields
R;L(R;)+R'D(O)D ( U"(~*
Z'(O) = - E[U'(¢r*)I0] E[ )~101

E [ U " ( ~ * ) I 0 ] E[U"(~r* ) ~10] } (A.10)

Given that ~ has zero mean, we have

E [ U " ( ~ * ) ~ I 0 ] =Cov[U"('h'*),~I0] < 0 , (A.11)
where the inequality follows from prudence (i.e., U'> 0) and the fact that
7r *(0, e) is a decreasing function of e. By DARA in Ross' sense, condition A.2,
we get

- U"[vr*(O,O)] >-- U'[~r*(O,e)] for all ~. (A.12)

Multiplying both sides of inequality A.12 by U'[~r*(O,e)]/E[U'('Tr*)IO] and

taking expectations with respect to G yields
U"[Tr* (0,0)] E[U"(~r*)I0]
- U"[Tr*(0,0)] >-- E[V'(~r*)[0] " (A.13)

Since 7r *(0, e) is a decreasing function of e, it follows from DAP that

U " [ ~ * (0, e)] V"'[~* (0,0)1
- U"[~'*(0, E)] > - ( - < ) - V"[qr*(0,0)] for e>_(_<)O. (A.14)

Multiplying both sides of inequality A.14 by -U"['n" *(0, E)]e and taking expec-
tations on both sides with respect to G yields

>_

>--
270 K.P. Wong / Journal of Banking & Finance 21 (1997) 251-271

where the second inequality follows from inequalities A. 1 land A.13. Hence, the
expression inside the curly brackets of Eq. (A.10) is positive.
Since Z'(O) < O, we have
Z(O)<(>)Z(O) for 0>(<)3, (A.15)
where 0 solves M(t~)=0. Multiplying E[U'(#*)IO]M(O) to both sides of
inequality A.15 and taking expectations with respect to F yields

where the second equality follows from Eq. (7). The desired result then follows
from Eq. (19). []

A.4. Proof of Proposition 8

To prove this proposition, it suffices to show that the second term on the
right-hand side of Eq. (21) can be positive. Suppose that Eq. (3) is a linear
regression model, i.e., R p(O)~ oz + tO, where a and /3 are positive constants.
Then, E[U"(~" * )M(O)(R o - Ro)] can be expressed as
/3 E[ U"(~'* )M((9) ((9- (9)] +/3 E[ U"(~r* ) M ( 0)] ((~- 0)

+ E[ U"(~r*)M((9) g], (A.16)

where (9 is defined by M((9) = 0. By Proposition 7, we know that the third term of
(A.16) is positive under DARA in Ross' sense and standard risk aversion. Given
that M' < 0, we know that M((~) and (~- (9 have opposite signs. Thus, the first
term of Eq. (A.16) is positive. Note that 0 > 0 because M' < 0 and M(0) >
M(0)---0 by condition 11. Hence, the second term of Eq. (A.16) is also positive
by the fact that E[U"(~" * )M(0)] _> 0 under DARA in Ross' sense. This completes
our proof. []

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