Authors: Antonis Vatistas, Andreas Andrikopoulos

Title: Real options in banking: Investment flexibility and loan portfolios

Abstract

ABSTRACT

The discounted cash flow method, due to the static nature of its results, often does not adequately help managers in making decisions for the implementation of investment projects. The operating flexibility of managers to adapt their decisions to the new market data and the uncertainty of the economic environment that they are called to face on a daily basis, have led to the development of the real option analysis. From this starting point, we apply the real-options approach to assess the business decisions that are made by bankers with respect to loan portfolios. We show that banks have a hidden value in their portfolios, which comes from the option to abandon the investment through lending. This option resembles an American put option. The valuation of the option to abandon can be applied just as successfully to both Non-Performing Loan portfolios and Performing Loan Portfolios. We employ the binomial model of Cox, Ross and Rubinstein (1979) to assess the option of banks to abandon, through the sale of their non-performing loan exposures. Our analysis takes place in the context of a hypothetical financial institution, Astir Bank. The financial data of Astir Bank were based on the average of Greek banks in the 3rd quarter of 2020.  Our findings indicated that there is hidden value in loan portfolios, equal to the option to sell non-performing loans, which is an option to abandon in a real-options context.