Are banks risk-averse or risk-neutral investors?

Abstract

In this study, we verify how to construct the utility maximization problem for banks in their asset allocation. We consider two utility maximization problems for the risk-averse and risk-neutral banks to determine the optimal lending ratios to represent banks’ optimal asset allocation. We apply the mean–variance utility for the risk-averse problem and impose the risk constraint for the risk-neutral problem to obtain the optimal solution. In order to validate the model, we investigate how the optimal lending ratios derived from the two models fit the actual bank lending ratio through calibration. Statistical tests for the calibration results do not indicate a significant difference in the model fitting between the risk-averse and risk-neutral models. Hence, this enables us to use both models to describe banks’ asset allocation.