Liability management of financial intermediaries in a dynamic and uncertain perspective

Abstract

This paper examines the effect of rate uncertainty (first for the loan rate alone, next for both asset and liability rates) on the liability-funding decisions of a risk-neutral intermediary. In this model a la Pindyck, rates evolve according to stochastic processes, convex adjustment costs arise from the dichotomy of existing (core) deposits and new savings balances, and the intermediary's cash flow is embedded into capital market theory. Then we show that the stationary equilibrium obtains at the intersection of the locus of no change in deposit holdings with the isocline of zero change in savings balances. Loan-rate uncertainty alone shifts the savings isocline outward, when marginal adjustment costs are rising at an increasing rate; but when asset and liability rates are uncertain, their impact on the mean intermediation spread, core deposit holdings and adjustment costs depends on whether they are correlated or not.