PREDICTABILITY OF RESERVE DEMAND, INFORMATION COSTS, AND PORTFOLIO BEHAVIOR OF COMMERICAL BANKS

AMONG THE most difficult problems facing a banking firm is the existence of uncertainty concerning various aspects of its activities. One of the main types of uncertainty a bank has to deal with is uncertainty about in- and outflows of cash reserves over the course of a given planning period. This uncertainty arises from two sources: First, the bank does not exactly know in advance what in- and outflows it will experience in its deposit accounts. Second, the bank faces uncertainty about the repayment of (matured) loans (due to the existence of default risk), and possibly also about the granting of new loans (if it gives some of its customers automatic borrowing privileges). This uncertainty induces banks to carry inventories of cash reserves 'into the period. To hold such inventories reduces the risk of reserve deficiencies during the period and of the costs of portfolio adjustments forced upon the bank by that event. Some authors, (see expecially Alchian, [1]) emphasize the economizing on information costs as the main economic function of inventories. A bank can use real resources (including time) in order to acquire more information about its customers and reduce the degree of uncertainty it faces. Existing models of bank reserve management do not consider this additional option of the bank.' This paper endogenizes information activity and consequently the degree of uncertainty. Marginal information costs are assumed to be no longer infinite but positive and finite. In Section II we will develop a banking model incorporating information activities. The optimal level of information expenses and the optimal composition of the bank's assets will be determined simultaneously. The comparative statics of the model are presented in Section III. Finally, in Section IV we discuss some implications of the results obtained from our model for general equilibrium systems with disaggregated financial sectors.