BANK FINANCING AND INVESTMENT DECISIONS WITH ASYMMETRIC INFORMATION ABOUT LOAN QUALITY

Banks know more about the quality of their assets than do outside inve stors. This informational asymmetry can distort investment decisions i f the bank must raise funds from uninformed outsiders. We model the ef fect of asymmetric information about loan quality on the asset and lia bility decisions of banks and the market valuation of bank liabilities . The existence of a precautionary demand for riskless securities agai nst future liquidity needs depends on both the regulatory environment and the informational structure. If banks are ex ante identical, they prefer issuing risky debt to fund a withdrawal to holding riskless sec urities ex ante. If banks have partial knowledge of loan quality, howe ver, high-quality banks may hold riskless securities to signal their q uality, enabling them to issue risky debt at a lower interest rate. We present new empirical evidence that banks with higher asset quality d o in fact hold more cash and securities.