Monetary and Economic Studies Vol.19, No.2 / May 2001

Uncertainty, Monitoring Costs, and Private Banks' Lending Decisions in a Duopolistic Loan Market: A Game-Theoretic Real Options Approach

Naohiko Baba

This paper explores banks’ entry decisions into a duopolistic loan market to shed light on the prolonged slump in the Japanese loan market in the 1990s. The game-theoretic real options approach is employed to analyze the effects of uncertainty on lending decisions. Special emphasis is given to the differences resulting from the alternative assumptions regarding whether the roles of leader and follower are interchangeable or predetermined. The theoretical model shows that when the roles are predetermined as in the case of the Japanese main bank system, both leader and follower banks have a greater incentive to wait until the loan demand condition improves sufficiently than when the roles are interchangeable. The numerical analysis shows that a rise in the demand volatility raises threshold values of current demand, which raises the incentive to wait for both leader and follower banks. In contrast, the direction of the effect of a change in the expected growth rate of demand depends on the assumptions regarding which parameter is adjustable, the risk-adjusted discount rate, or the dividend rate. The effects of a change in the probability of bankruptcy of a borrowing firm and the interest rate elasticity of loan demand are also examined.

Keywords: Bank lending; Uncertainty; Entry decision; Monitoring costs; Duopolistic market; Real options; Stochastic game

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2001 Bank of Japan All Rights Reserved.

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