The Bank's Choice of Financing and the Correlation Structure of Loan Returns

This paper examines how the correlation structure of loan returns within a bank s loan portfolio a.ects its choice of .nancing when the bank faces binding capital constraints and there is asymmetric information about the quality of its loans.The paper uses an asymmetric information model similar to Myers and Majluf (1984), where a bank must raise its equity-toassets ratio either by issuing equity or by selling loans in the secondary market.The results suggest that the correlation structure of loan returns can have signi.cant in.uence on the cost of issuing equity since it a.ects the variance of a banks loan portfolio. However, it is shown that a bank will always prefer to sell loans instead of equity if it has favorable inside information for some of its loans and unfavorable information for some of its other loans.