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Abstract
This model concerns itself with how banks hedge their business risk, as composed of cash-flow risk and discount rate risk. In equilibrium, the two risks are intertwined as they are linked via the optimal hedging strategy. Ultimately, the bank stabilizes the marginal value of cash to trade off discount and cash flow effects. A regulator imposes a maximum leverage ratio, and the firm鈥檚 strategy is affected differentially depending on if the regulator imposes the limit on accounting or market variables. We show that when a bank鈥檚 deposit rate beta, loan beta, and deposit growth beta are zero that the bank optimally hedges away all interest rate risk. If not, then it retains some optimal net exposure to interest rate risk: A bank鈥檚 excess returns on loan and deposits, as well as equity and deposit flows, make up a bank鈥檚 investment opportunity set, and if this changes with r it is optimal to induce some state dependence of capital to r.
