Bank as a liquidity provider and interest rate discovery: An option-based optimization

Lending via commitment provides liquidity and interest rate discovery. These two concepts are closely related, but they are not identical. As each function can influence asset prices (and thus equity capital prices), this paper discusses how liquidity enters into equity capital price formation, and then focuses on the impact of the price discovery process on bank interest rate behavior. We use an option-based model to study the average loan interest rate of the other banks (explicitly treated as interest rate discovery in our model), the degree of capital market imperfection, and the external financing need for determining the bank's optimal loan rate and loan commitment rate, and thus the default risk of its net return. We find, for example, that the default risk of the bank's net return is negatively related to the average loan rate of the other banks and the external financing need, and positively related to the degree of capital market imperfection. Our findings provide alternative explanations for implications concerning liquidity and price discovery. (C) 2005 Elsevier Ltd. All rights reserved.