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Managing the risk of loans with basis risk: sell, hedge, or do nothing?

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  • Larry D. Wall
  • Milind M. Shrikhande

Abstract

Individual loans contain a bundle of risks including credit risk and interest rate risk. This paper focuses on the general issue of banks’ management of these various risks in a model with costly loan monitoring and convex taxes. The results suggest that if the hedge is not subject to basis risk, then hedging dominates a strategy of “do nothing.” Whether hedging dominates loan sales depends on whether it induces reduced monitoring, the net benefit of monitoring, and the reduced tax burden of eliminating all risk via selling. If the hedge is subject to basis risk, then a “do nothing” strategy may dominate the hedging and loan sales strategy for risk neutral banks. A number of empirical implications follow from the analytical and numerical results in the paper.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2000-25.

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Date of creation: 2000
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Handle: RePEc:fip:fedawp:2000-25

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Keywords: Loan sales ; Hedging (Finance) ; Risk management;

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  1. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 391-405, December.
  2. Jones, David, 2000. "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 35-58, January.
  3. Pennacchi, George G, 1988. " Loan Sales and the Cost of Bank Capital," Journal of Finance, American Finance Association, vol. 43(2), pages 375-96, June.
  4. Robert S. Neal, 1996. "Credit derivatives: new financial instruments for controlling credit risk," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 15-27.
  5. Tom Copeland & Maggie Copeland, 1999. "Managing Corporate FX Risk: A Value-Maximizing Approach," Financial Management, Financial Management Association, vol. 28(3), Fall.
  6. Buser, Stephen A & Chen, Andrew H & Kane, Edward J, 1981. "Federal Deposit Insurance, Regulatory Policy, and Optimal Bank Capital," Journal of Finance, American Finance Association, vol. 36(1), pages 51-60, March.
  7. Rebecca S. Demsetz, 1999. "Bank loan sales: a new look at the motivations for secondary market activity," Staff Reports 69, Federal Reserve Bank of New York.
  8. James T. Moser, 1998. "Credit derivatives: just-in-time provisioning for loan losses," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q IV, pages 2-11.
  9. Allen N. Berger & Gregory F. Udell, 1991. "Securitization, risk, and the liquidity problem in banking," Finance and Economics Discussion Series 181, Board of Governors of the Federal Reserve System (U.S.).
  10. Credit Derivatives: Is It Always Good to Have More Risk Management Tools? Gregory Duffee 96-42 Banks & Chungsheng Zhou, 1996. "Banks and Credit Derivatives: Is It Always Good to Have More Risk Management Tools?," Center for Financial Institutions Working Papers 96-42, Wharton School Center for Financial Institutions, University of Pennsylvania.
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