Mortgage Loans and Bank Risk Taking: Finding the Risk 'Sweet Spot'

A vast body of academic literature deals with banks' optimal loan allocations. The general approach to solving this problem is to assume borrowers' portfolios as given. Although this assumption is reasonable in the corporate sector, the situation differs radically in the mortgage markets, where borrowers are unobservable and banks' screening capacity is tightly limited. We propose a novel dynamic model that assumes potential mortgage takers arrive randomly and sequentially at a bank. In a simulation, we show that the effect of a more stringent level of perceived risk on a bank's expected net income can be positive or negative. Remarkably, if both level of wealth inequality and screening capacity are low, a more severe level of perceived risk can decrease a bank's expected net income. In this situation, regulators should be particularly careful about increasing regulation in the form of a lower loan-to-value ratio.