A barrier option framework for bank interest margin management under anticipatory regret aversion

•We propose a barrier option framework for bank equity valuation.•Anticipatory regret aversion is characterized by a down-and-in option.•The interest margin is the spread between the loan rate and the deposit rate.•The margin with low barrier is negatively related to regret aversion.•Regret aversion as such adversely affects the stability of banking system.

This paper proposes a framework for bank equity valuation based on a path-dependent, barrier option model. A direct implication of this framework is that bank equity will be priced as a down-and-out call option. Using this approach, we examine how bank interest margin, i.e., the spread between the loan rate and the deposit rate, is determined when a bank is regret-averse. Regret-averse preferences are characterized by a down-and-in call, which is specified as the difference between a standard call and a down-and-out call. The model demonstrates how anticipatory regret aversion and the default barrier jointly determine an optimal bank interest margin decision. We find that a bank interest margin with a low level of default barrier is negatively related to anticipatory regret aversion and to the default barrier. Regret aversion and default barriers make a bank less prudent and more prone to risk-taking, thereby adversely affecting the stability of the banking system.