ASSET MANAGEMENT AND COMMERCIAL BANK PORTFOLIO BEHAVIOR: THEORY AND PRACTICE

Abstract

THIS PAPER REPORTS the results of an investigation we have conducted regarding two aspects of commercial bank portfolio management. With regard to the first aspect, two alternative hypotheses regarding bank behavior are tested. These are the implied in the commercial loan theory of banking and the maximization implied in recent developments in bank portfolio theory and related research. The second aspect is an investigation into the proposition that there has been a significant change in bank portfolio behavior in recent years. Knowledge of the first aspect of commercial bank behavior is important for monetary management. The accommodation principle implies that the demand for bank loans determines bank portfolio behavior. On the other hand, the profit maximization principle implies that commercial bank responses to market forces determine their portfolio behavior. Expectations of bank response to actions of the Federal Reserve System differ according to which principle is accepted. For example, under the accommodation principle, Federal Reserve openmarket operations slowing growth in the reserve base could have little effect on growth in the volume of bank loans if the demand for such loans, at given interest rates, was expanding rapidly. Such would be the case if economic activity was expanding rapidly. Thus, loans could continue to rise at the previous rate or even to accelerate if demand should strengthen. Banks would tend to accommodate such demand by shifting out of investments. By comparison, in such circumstances of Federal Reserve restraint, profit maximization would induce banks to reduce the rate of growth of both loans and investments, at given interest rates, with loan growth continuing at its previous rate only if interest rates on loans rose relative to interest rates on investments. Changes in bank portfolio behavior, the second aspect of this investigation, have important implications for monetary management. A change in commercial bank portfolio behavior may be reflected in a shift in a function, a change in the shape of the function, or both. For example, with regard to bank loans, a shift in the function explaining the desired level would be reflected in a change in its intercept. A change in its shape would be a change in the elasticity of the desired level of loans with regard to one or more of its arguments. Monetary authorities, when attempting to forecast the asset behavior of banks in response to a given change in monetary policy, must take into consideration empirical evidence bearing on these questions. If the central bank