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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.

Suggested Citation

  • Inderst, Roman & Mueller, Holger M, 2003. "Credit Risk Analysis and Security Design," CEPR Discussion Papers 3686, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:3686
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    References listed on IDEAS

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    Cited by:

    1. repec:nbr:nberch:3049 is not listed on IDEAS
    2. Roland Strausz, 2009. "Entrepreneurial Financing, Advice, and Agency Costs," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 18(3), pages 845-870, September.
    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.
    4. Axelson, Ulf, 2005. "Security Design with Investor Private Information," SIFR Research Report Series 37, Institute for Financial Research.

    More about this item

    Keywords

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

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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