With the process of deregulation of interest rates, the administered interest rates structure has been dismantled and banks are getting control over their interest rate decisions. However, the decisions of setting credit and deposit rates cannot be modeled efficiently as a single player’s optimization exercise. It should be the outcome of a game that is played between three interested players: the bank, the firm and the consumer. These agents are related as funds are channeled from savings by the consumer to investment by the firm through an intermediary which is a bank. Each player’s dynamic choices impacts on the strategic decisions of the others. The dynamic game designed by us is a state-space game where the equilibria that are considered are of the open-loop type. We have derived a relationship between credit risk and the expected rate of return of the bank’s portfolio. Consequently, the optimal credit risk and the corresponding equilibrium credit and deposit rates are determined. This equilibrium is a rationing one where certain demands for loans are rationed even if some borrowers are willing to pay more than the equilibrium credit rate.
JEL Classification Code: G21, G12, E43
Key Words: Deregulation, Credit Risk, Open-Loop Strategy, Dynamic Game, Credit Rationing