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|Title: ||Credit Risk Analysis and Security Design|
|Authors: ||Inderst, Roman|
Müller, Holger M.
|Issue Date: ||Nov-2002 |
|Series/Report no.: ||FIN-02-059|
|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
otype-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.|
|Appears in Collections:||Finance Working Papers|
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