Optimal allocation between bank loans and treasuries with regret

Abstract

The main categories of assets held by banks are loans, Treasuries (bonds issued by the national Treasury), reserves and intangible assets. In our contribution, we investigate the investment of bank funds in loans and Treasuries with the aim of generating an optimal final fund level. Our results take behavioral aspects such as risk and regret into account. More specifically, we apply a branch of optimization theory that enables us to consider a regret attribute alongside a risk component as an integral part of the utility function. In this case, regret-aversion corresponds to the convexity of the regret function and the bank’s preference is assumed to be representable by optimization subject to the utility. In addition, we provide a comparison between risk- and regret-averse banks in terms of optimal asset allocation between loans and Treasuries. A feature of our contribution is that these and other optimization issues are analyzed briefly and, where possible, represented graphically. Furthermore, we comment on the claim that an investment away from loans towards Treasuries is responsible for credit crunches in the banking industry.