Banks as interest rate managers

Most banks have a two-tier pricing system, offering accounts at market-rela ted interest rates and at posted rates that are changed at discrete interva ls. In this paper, I develop a model of bank interest rate management. I co nsider a bank with two classes of loans and deposits in its balance sheet: One pays a market rate of interest, the other a posted rate. Market rates a re exogenous and evolve stochastically over time. Posted rates are altered intermittently by the bank itself. The bank faces imperfect arbitrage by it s customers between posted and market rate funds. Under simple assumptions about the stochastic process governing the market rate, I derive optimal de cision rules for the adjustment of the posted rate and determine conditions under which these rules are asymmetric. A key prediction of the model is a negative correlation between market loan rates and the "gap"; this is more consistent with the behavior of British banks than is the contrary predict ion of more "standard" models.