International diversification puzzle: optimal bank interest margin and risk aversion

This paper explores international lending and its diversification puzzle by analyzing the risk aversion effects on optimal bank interest margin decisions based on a model under exchange-rate risk. The optimal loan portfolio consists of three alternative contracts (domestic loan only, foreign loan only, and some combination of the two), and hence the international diversification puzzle in Baxter and Jermann’s sense (1997) reveals. The nonlinear preference effects on optimal loan-rate decisions depend on the optimal composition of the loan portfolio. For a bank facing exchange-rate risk, the optimal deposit rate is higher when the bank is risk averse than when the bank is risk neutral. Our findings provide an alternative explanation for bank spread behavior and international diversification puzzle.