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Credit Risk Analysis and Security Design

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  • 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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Bibliographic Info

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

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References

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

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