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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.

Suggested Citation

  • Larry D. Wall & Milind M. Shrikhande, 2000. "Managing the risk of loans with basis risk: sell, hedge, or do nothing?," FRB Atlanta Working Paper 2000-25, Federal Reserve Bank of Atlanta.
  • Handle: RePEc:fip:fedawp:2000-25
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    References listed on IDEAS

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    1. Pennacchi, George G, 1988. " Loan Sales and the Cost of Bank Capital," Journal of Finance, American Finance Association, vol. 43(2), pages 375-396, June.
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    3. Robert 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.
    4. 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.
    5. 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.
    6. 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.).
    7. 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.
    8. 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.
    9. Tom Copeland & Maggie Copeland, 1999. "Managing Corporate FX Risk: A Value-Maximizing Approach," Financial Management, Financial Management Association, vol. 28(3), Fall.
    10. Beverly Hirtle, 1997. "Derivatives, Portfolio Composition, and Bank Holding Company Interest Rate Risk Exposure," Journal of Financial Services Research, Springer;Western Finance Association, pages 243-266.
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    Cited by:

    1. Heidorn, Thomas & Mokinski, Frieder & Rühl, Christoph & Schmaltz, Christian, 2015. "The impact of fundamental and financial traders on the term structure of oil," Energy Economics, Elsevier, pages 276-287.

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    Keywords

    Loan sales ; Hedging (Finance) ; Risk management;

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