A MODEL OF THE MARKET FOR LINES OF CREDIT

CONSIDERABLE PROGRESS has been made in recent years in constructing positive economic models of the behavior of financial institutions. Some of those who have been responsible for this progress have set out to explain the role of financial institutions in organized financial markets (see, for example, David Pyle [10]) while others have sought to develop an analytical foundation for observed behavior in specific kinds of financial markets (see Dwight Jaffee's study of credit rationing in the commercial loan market [6]). This paper is concerned with developing a model of both the demand for and the supply of particular types of financial services provided by commercial banks, lines of credit and revolving credit agreements. The model of the markets for these specific loan agreements formulated here is intended as a contribution to the emerging positive theory of the role of financial institutions. This study is motivated by the absence in the finance and economics literature of any theoretical or empirical analysis of these markets. The purpose of the study is fourfold: to analyze the determinants of the demand for lines of credit and revolving credit agreements; to explain the bank's optimal price structure for these types of loans; to explain the economic significance of the distinction between a line of credit and a revolving credit agreement; and to examine the impact of these agreements on the effectiveness of monetary policy. An important result presented in this paper pertains to the role currently played by lines of credit in the conduct of monetary policy. One of the arguments used to justify the use of an interest rate rather than an aggregate target for monetary policy is that banks must be permitted to honor lines of credit. It is argued that these loan commitments prevent the Fed from exercising significant control over the aggregates during periods of credit expansion. The hypothesis developed in this paper is that the line of credit, as distinct from the revolving credit agreement, has evolved at least in part to circumvent the prohibition of interest payments on demand deposits, and that, without this prohibition, the interest rate target would lose some of its present appeal. This hypothesis follows from a theoretical analysis of what will be termed fixed rate and fixed formula loan agreements. The theoretical treatment, which abstracts from the specific characteristics of lines of credit and revolving credit agreements, is presented in Sections II and III. A model of the fixed rate loan agreement is developed in Section II. A fixed rate loan agreement refers to a contract between a bank and a borrower which stipulates that the bank will provide a loan upon