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Credit Risk Analysis and Security Design

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Author Info
Inderst, Roman
Mueller, Holger M
Abstract

This Paper considers the potential cost of subjective judgement and discretion in credit decisions. We show that subjectivity and discretion in the evaluation of borrowers create an incentive problem on the part of the lender. The lender's incentives to accept or reject a borrower depend only on the value of her own claims, not on the total value of the project. Unless the lender obtains the full NPV her credit decision is too conservative, i.e., she uses too high a hurdle rate. Given this problem we show that the unique optimal security is standard debt. Among all securities, debt is the one that makes the lender the least conservative, thus providing her with optimal incentives to trade off type-1 and type-2 errors. Among other things, this suggests that the common folk wisdom whereby giving banks equity makes them less cautious in their credit decisions is generally not correct.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3686.

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Date of creation: Feb 2003
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Handle: RePEc:cpr:ceprdp:3686

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Related research
Keywords: banking; credit decision; credit risk analysis; security design;

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Find related papers by JEL classification:
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Axelson, Ulf, 2005. "Security Design with Investor Private Information," SIFR Research Report Series 37, Institute for Financial Research. [Downloadable!]
  2. Roland Strausz, . "Entrepreneurial Financing, Advice, and Agency Costs," Papers 022, Departmental Working Papers. [Downloadable!]
    Other versions:
  3. Roland Strausz, 2005. "Optimal Information Revelation by Informed Investors," Discussion Papers 34, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
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