Showing papers on "Credit risk published in 1994"

Did Risk-Based Capital Allocate Bank Credit and Cause a 'Credit Crunch' in the United States?

Abstract: This paper examines the reallocation of bank credit from loans to securities in the early 1990s using data on virtually all U.S. banks from 1979 to 1992. The authors investigate implementation of risk-based capital and other regulatory and nonregulatory changes as possible causes of a supply-driven credit crunch. The main empirical implication of these credit crunch hypotheses--that the reallocation of credit would be most associated with low-capital, high-risk banks--generally is not consistent with the data. Much of the reallocation is associated with demand-side factors but it is difficult to differentiate cleanly among these factors. Copyright 1994 by Ohio State University Press.

Using Default Rates to Model the Term Structure of Credit Risk

Abstract: (1994). Using Default Rates to Model the Term Structure of Credit Risk. Financial Analysts Journal: Vol. 50, No. 5, pp. 25-32.

The credit rating industry

Abstract: Investors and regulators have been increasing their reliance on the opinions of the credit rating agencies. This article shows that although the ratings provide accurate rank-orderings of default risk, the meaning of specific letter grades varies over time and across agencies. Noting that current regulations do not explicitly adjust for agency differences, the authors argue that a reassessment of the use of ratings and the adequacy of public oversight is overdue.

Pricing Swap Default Risk

Abstract: With the growth in the market for interest rate swaps has come a growing need to understand the potential default risks of these instruments. In general, swap participants can deal with default risk by seeking to mitigate it (by dealing only with AAA-rated counterparties, for example). Alternatively, potential counterparties can attempt to come to some agreement about the degree of default risk and use that knowledge to "price" their positions. A model of swap default risk evaluates jointly the probability of the swap counterparty defaulting and the cost (or impact) of the default for the solvent party. The model helps to establish the correct level for a swap between risky (or potentially risky) parties. The key considerations are the swap parties' credit conditions and the shape and volatility of the yield curve.

Effects of Low Income Families' Ability and Willingness to Use consumer Credit on Subsequent Outstanding Credit Balances

Abstract: The indebtedness of American households grew substantially in the last decade. The outstanding balance of all consumer credit, excluding mortgage debt, was $800 billion at the end of 1990. The growth of consumer credit exceeded the growth of after-tax family income in the 1980s (Canner and Luckett 1991). More than 80 percent of families had consumer installment debt, a type of consumer credit, as reported in the 1986 Survey of Consumer Finances (Avery, Elliehausen, and Kennickell 1987). In 1988, each household owed an average of $7,104 for automobile installment loans, $3,029 for revolving credit, $2,192 in other consumer debts, and $1,661 in credit card balances (U.S. Bureau of Census 1990, 133). During the decade from 1980 to 1990, a considerable portion of household income, an average of 17 percent, was spent to repay consumer credit (Calem 1992; Canner and Luckett 1991). Along with the growth of consumer credit, there was an increase in the use of consumer credit among families whose incomes were lower than the majority of families in the mid-1980s. REVIEW OF LITERATURE This research focuses on consumer credit use in low income families. Access to credit by low income families may be limited. Their applications for credit are more likely to be turned down than other income classes because of credit qualification policies. Families with a net weekly income of $360 and less had fewer chances of obtaining a credit commitment and thus having access to credit than the average income family (Berthoud and Kempson 1990). Low income people may not even apply for credit for fear of being rejected. Legally and reasonably priced credit was not generally available to low income families before 1980 (Bowers 1979). However, a dramatic change occurred in bank card holdings among low income consumers in the 1980s (Canner 1988). During the period from 1983 to 1986, the portion of families with incomes below $10,000 (1985 constant dollars) holding a credit card increased 91 percent. This increase is much greater than for any other income group. Low income groups still use less credit than higher income groups and have fewer credit commitments, according to the Household Credit Data Book (Krannert Graduate School of Management 1989). The credit practices of low income families are quite different from those of families at other income levels. According to Howells (1990) below average income groups tend to use credit to help cope with budgeting troubles instead of increasing purchasing power. Families earning less than $10,000 per year are much more likely to maintain high outstanding credit card balances and to treat those balances as a type of installment debt. Fewer of them are concerned about the service features of credit, that is, convenience, safety, or identification (Bowers 1979; Bowers and Crosby 1980). Low income households are least likely to be able to borrow at a low interest rate or to possess assets to pay debts and they are more likely to pay the minimum payment on their credit cards, which results in a substantial burden of interest payments (Boston Company Economic Advisor Inc. 1992). Research on credit use by low income families has not been sufficient to explain their consumer credit behavior. Many researchers have investigated the determinants of consumer credit use since the mid-1960s. The most commonly examined determinants of consumer credit use have been economic or sociodemographic variables, including annual family income, family assets, education, life cycle, gender, marital status, years at residence, size of household, ownership of an automobile, and housing status (Awh and Waters 1974; Canner and Cyrnak 1985, 1986; Canner and Luckett 1990, 1992; Courtless 1993; Danes and Hira 1990; Johnson and Sullivan 1981; Lindley, Rudolph, and Selby 1989; Tabor and Bowers 1977; Yeo 1991). A few researchers have studied consumers' attitudes toward credit use as an indicator of their willingness to borrow, accompanied by discussions of various reasons for credit use. …

Managing Commodity Price Risk in Developing Countries

Abstract: This book provides detailed information about financial instruments for managing external commodity price risks, creating awareness of the institutional constraints that must be removed to allow full access to these instruments, and illustrating the kinds of technical assistance and education needed to enable good use of the instruments in developing countries. It indicates the importance of improved commodity risk management in developing countries and identifies the role financial instruments can play in managing commodity price risk, providing access to external finance, and lowering credit risk. It describes how domestic schemes to stabilize commodity prices work and the experience that developing countries have had with such schemes. This book presents application of financial risk management instruments within the context of traditional domestic price stabilization schemes, further demonstrating the complementarity of the two. The financial instruments that are available for external risk management are discussed, focusing on instruments that manage commodity risk. In addition, the book discusses some of the practical and regulatory constraints to using commodity risk management instruments. The second part of the book contains case studies that are drawn either from the needs assessment surveys or from analysis and are intended to demonstrate the purpose, benefits, and costs of particular instruments or hedging strategies.

Swap Rates and Credit Quality

Abstract: The impact of credit quality on swap rates is determined under alternative netting assumptions. With counterparties of different default risk, swap valuation is non-linear in the underlying promised exchange of cash flows. The impact of credit risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps.

Do mortgage rates vary based on household default characteristics? Evidence on rate sorting and credit rationing

Abstract: Credit “screening models” suggest that lenders vary loan rates and debt ceilings across applicants on the basis of credit risk. We argue that regulatory constraints such as Fair Lending Laws may preclude rate sorting while increasing lender use of debt ceilings to adjust for applicant credit risk. Using household data from the 1983 SCF, we find that mortgage rates do not vary with applicant credit risk whereas related studies find that debt ceilings vary with borrower risk attributes. Together, these findings support arguments that regulatory constraints reduce rate sorting while increasing the use of non-price terms in the mortgage contract.

Crop insurance and crop credit: Impact of the comprehensive crop insurance scheme on cooperative credit in Gujarat

Abstract: This paper is an attempt to analyse the impact of a credit-linked crop insurance scheme—the Comprehensive Crop Insurance Scheme (CCIS) of India—on crop credit or short-term agricultural credit, especially to small fanners. A dominant view on rural credit institutions is that they are unwilling to extend adequate credit to small farmers on account of the problems of information and enforcement, and that a crop insurance scheme—because it faces similar problems—would make little difference. A common device used in rural credit markets with a view to limiting the consequences arising out of agricultural risk, information asymmetries and enforcement problems is collateral. Small farmers in developing countries do not own adequate land and other assets which can be used as collateral, and consequently face a situation of inadequate availability of credit. The question is whether crop insurance can serve as a substitute (perhaps partial) for collateral. In view of the above facts, this paper addresses the issues whether the CCIS led to a significantly higher flow of institutional credit to farmers, especially small farmers, and whether there was any improvement in the repayment of loan—in other words, whether there was any collateral effect. The analysis is based on empirical data from Gujarat (India). The findings show that there is a significant increase in the flow of credit to insured farmers after the introduction of the CCIS. The expansion is in both coverage and size—there was an increase in the number of borrowers, and also in credit per borrower as well as per hectare. The share of small farmers (with land holdings of 2 ha or less) in the total loan increased from 19 per cent to 27 per cent. There was a significant increase in the repayment of loan in absolute terms—repayment per farmer and repayment per hectare. But it is not clear if the propensity to repay improved. The expansion of credit appears to be what one may call a collateral effect.

Margins and the safety of clearing houses

Abstract: The major distinguishing feature of a futures market is the system of margining. In providing a guarantee, the clearing house bears the risk that price changes will exceed the initial margin, (a market risk), and that members will be unable to pay, (a credit risk). By bad judgement or management it is possible for clearing houses to fail, as happened in Hong Kong in 1987. This paper examines the capital required by clearing houses, using the International Commodities Clearing House in London as an example. Given the level of margining in 1987, it is found that exposure might exceed £40 million about once per year and £200 million once per thirty years. ICCH needs credit lines to cover these levels of exposure, plus enough capital to cover the proportion of these that are defaulted. These capital requirements are much smaller than they would be if only one market were being margined — there is a large diversification gain from clearing many futures markets. How the capital should be obtained — through shareholders' equity, by forming a mutual association, or by purchasing insurance — is discussed.

Credit Losses in Nordic Banks

Abstract: In the 1980s the central banks of the Nordic countries began to deregu- late their financial markets. Within the space of a few years, several of the existing regulations were abolished that had for long restricted banks' lending volumes, interest rate setting and foreign exchange. For the banks a door was opened to a new world; the changed environment offered exciting business opportunities. The demand for new loans seemed almost infinite, but simultaneously the competition between banks, and between banks and other financial institutions, was strength- ened. Therefore, many banks reorganised and decentralised their busi- ness. Competitiveness and market (customer) orientation became buzz words and were considered by many banks to be strategical key factors for success. Branches became profit centres and, within certain limits, the authority to make credit decisions was often delegated to the local branch manager. The new world, however, was also a world of which most of the banks had no real experience and, apparently, very limited understanding. Today it is obvious that the majority failed to realise the magnitude of the underlying credit risk exposure when expanding the loan portfolio.

The Welfare Implications of Costly Monitoring in the Credit Market

Abstract: Rationing is a pervasive feature of credit markets. It has been suggested that credit rationing represents a suboptimal allocation of resources. In a general equilibrium model of credit rationing with hidden information and costly monitoring we show that if credit is rationed it is suboptimal but that credit should be rationed more tightly. In equilibrium, loan applicants bear average monitoring costs, whereas for efficiency they should bear marginal monitoring costs which are larger because average monitoring costs increase with quantity as extra loans are accompanied by a rise in the interest rate which increases the number of defaults. Copyright 1994 by Royal Economic Society.

Household Use of Open‐End Credit to Finance Risk

Abstract: Consumers face many risks which can neither be avoided nor completely controlled. Personal property, for example, is exposed to such risks as fire, theft, vandalism, and product defects. After taking precautions to minimize the frequency and severity of potential losses, the household must decide what proportion of the residual risk to retain and what proportion to transfer to outside agents through contingent claims contracts. A related question, and one which has been less extensively studied, is the degree to which retained risk should be financed on a preloss or postloss basis; that is, with cash or credit. This paper addresses both issues by examining the use of open-end consumer credit as a means of financing household risk. The two dimensions of the risk financing problem create four options, as shown in Table 1. As the table suggests, postloss transfers in the form of retroactive insurance--that is, policies providing back-dated coverage--do exist (Smith and Witt 1985), but the vast majority of transfers involve preloss financing, in which a surety contract is purchased prior to a loss. Thus, the risk of accidental property loss is often transferred to an insurance company, while the risk of product failure may be transferred by purchasing an extended warranty from the manufacturer or a service contract from a third party. Retained risk, on the other hand, has traditionally been financed through self-insurance, in which the consumer sets aside a pool of emergency funds for possible future use in the event of a loss. Although preloss transfers and self-insurance are perhaps the most common methods of financing risk, they may not always be the most economical. The alternative is to establish open-end credit so that funds are available for contingencies, but no expense is incurred unless and until a loss actually occurs. Using credit guarantees to finance risk is a familiar technique in corporate risk management (e.g., Doherty 1985), and during the last two decades, the issuance of standby letters of credit by commercial banks has proceeded at a rapid pace (Goldberg and Lloyd-Davies 1985; Koppenhaver and Stover 1991). Similarly, the use of credit to finance risk is becoming increasingly popular among consumers. As Hayes recently observed, "Many consumers now seem to use credit to smooth out the effects of temporary economic fluctuations and to maintain living standards" (1989, 19). But an analysis of this option has been neglected in most of the literature on household risk management. Even leading textbook authors, such as Williams and Heins (1989), are silent on this issue. This paper attempts to fill the void by including consumer credit in a model of risk financing. Under certain conditions derived below, using credit can be a more affordable and more flexible method of financing small household risks, particularly risks to personal property. The paper is organized as follows. First, consumer credit is compared with preloss insurance coverage as a means of financing risk. (Because it is virtually unavailable to consumers, retroactive insurance is not considered.) A two-period utility maximization model is used to define the conditions under which postloss credit financing is preferred to insurance. The model is then reinterpreted in order to compare consumer credit with product service plans. Next, credit is compared with the traditional self-insurance method of retention. A brief discussion section concludes the paper. TABLE 1 Risk Financing Methods TRANSFER RETENTION PRELOSS insurance self-insurance service contracts warranties POSTLOSS retroactive insurance credit INSURANCE VERSUS CREDIT Insurance policies covering personal property such as automobiles require the payment of premiums in advance of coverage and on a continuing basis, in return for contingent claims in the event of a loss. …

Structuring credit to manage real risks.

Abstract: If half the effort that has been spent throwing credit at the frontier [of formal finance] had been devoted to stimulating voluntary savings mobilization, the financial landscape in much of the Third World would probably be more attractive today. (And if the other half had been devoted to managing risk in credit relationships... this financial landscape would be a lush garden.) -Finance at the Frontier (page 97)

The Role of Interest Rate Swaps in Corporate Finance

Abstract: An interest rate swap is a contractual agreement between two parties to exchange a series of interest rate payments without exchanging the underlying debt. The interest rate swap represents one example of a general category of financial instruments known as derivative instruments. In the most general terms, a derivative instrument is an agreement whose value derives from some underlying market return, market price, or price index. The rapid growth of the market for swaps and other derivatives in recent years has spurred considerable controversy over the economic rationale for these instruments. Many observers have expressed alarm over the growth and size of the market, arguing that interest rate swaps and other derivative instruments threaten the stability of financial markets. Recently, such fears have led both legislators and bank regulators to consider measures to curb the growth of the market. Several legislators have begun to promote initiatives to create an entirely new regulatory agency to supervise derivatives trading activity. Underlying these initiatives is the premise that derivative instruments increase aggregate risk in the economy, either by encouraging speculation or by burdening firms with risks that management does not understand fully and is incapable of controlling.(1) To be certain, much of this criticism is aimed at many of the more exotic derivative instruments that have begun to appear recently. Nevertheless, it is difficult, if not impossible, to appreciate the economic role of these more exotic instruments without an understanding of the role of the interest rate swap, the most basic of the new generation of financial derivatives. Although the factors accounting for the remarkable growth of the swaps market are yet to be fully understood, financial economists have proposed a number of different hypotheses to explain how and why firms use interest rate swaps. The early explanation, popular among market participants, was that interest rate swaps lowered financing costs by making it possible for firms to arbitrage the mispricing of credit risk. If this were the only rationale for interest rate swaps, however, it would mean that these instruments exist only to facilitate a way around market inefficiencies and should become redundant once arbitrage leads market participants to begin pricing credit risk correctly. Thus, trading in interest rate swaps should die out over time as arbitrage opportunities disappear-a prediction that is at odds with actual experience. Other observers note that the advent of the interest rate swap coincided with a period of extraordinary volatility in U.S. market interest rates, leading them to attribute the rapid growth of interest rate derivatives to the desire on the part of firms to hedge cash flows against the effects of interest rate volatility. The timing of the appearance of interest rate swaps, coming as it did during a period of volatile rates, seems to lend support to such arguments. Risk avoidance alone cannot explain the growth of the swaps market, however, because firms can always protect themselves against rising interest rates simply by taking out fixed-rate, long-term loans or by bypassing credit markets altogether and issuing equity to fund investments. Recent research emphasizes that interest rate swaps offer firms new financing choices that were just not available before the advent of these instruments, and thus represent a true financial innovation. This research suggests that the financing choices made available by interest rate swaps may help to reduce default risk and may sometimes make it possible for firms to undertake productive investments that would not be feasible otherwise. The discussion that follows explains the basic mechanics of interest rate swaps and examines these rationales in more detail. 1. FUNDAMENTALS OF INTEREST RATE SWAPS The most common type of interest rate swap is the fixed/floating swap in which a fixed-rate payer promises to make periodic payments based on a fixed interest rate to a floating-rate payer, who in turn agrees to make variable payments indexed to some short-term interest rate. …

Default Risk, Firm Characteristics, and the Valuation of Variable-Rate Debt Instruments

Abstract: This paper extends the valuation framework developed by Ramaswamy and Sundaresan (1986) to examine the relationship between the risk premium on corporate issues of variable-rate, or floating-rate, debt instruments, and the issuer's risk of default. The investor's expected loss on default of any issue is modeled as a call option written on the stochastic values of future bond payments and the firm's value. Evidence from a sample of 154 U.S. corporate floaters issued over the period 1978 to 1991 shows that investors demand significantly lower risk premiums when positive and large correlations between the issuing firm's operating cash flows and index interest rates are present. There is also evidence concerning the existence of some structural differences in risk premiums based on the issuer's industry and the types of indices used. The impact of callability / puttability and several other market and firm-specific variables are also tested.

Rating the states: credit rating agencies and the Australian state governments. by David Hayward & Mike Salvaris

Abstract: tag=1 data=Rating the states: credit rating agencies and the Australian state governments. by David Hayward & Mike Salvaris tag=2 data=Hayward, David%Salvaris, Mike tag=3 data=Journal of Australian Political Economy, tag=5 data=34 tag=6 data=December 1994 tag=7 data=1-26. tag=8 data=CREDIT tag=10 data=Two major credit rating agencies operate in Australia - Moody's Investor Services, and Standard and Poor's. They offer credit risk assessments of public and private organisations seeking to borrow funds on the capital markets. tag=11 data=1995/1/1 tag=12 data=95/0096 tag=13 data=CAB

Netting agreements and the credit exposures of OTC derivatives portfolios

Abstract: The rapid expansion of the over-the-counter derivative market has prompted dealers to lessen their credit risk exposure by adopting bilateral closeout netting agreements. This article shows that netting agreements will not only reduce current credit exposure but under certain circumstances will also dampen fluctuations in the volatility of dealers' exposures. Thus, netting agreements may limit potential credit exposure, or the possibility that credit exposure will increase over a fixed time horizon.

Loan Size Limits: A Simple Model

Abstract: 16 THE JOURNAL OF COMMERCIAL LENDING cal change and must continue to improve their measurements of credit risk and the associated pricing of that risk. Conclusion I have touched on the profound changes in the business of lending that have occurred in only the past several years. It is easy to speculate that many more such changes will occur in the not so distant future. I have no doubt that bankers will arrive at these new horizons with receptive minds and a willingness to embrace the best of the new ideas. The industry will benefit and, I am sure, so will its customers and the general economy. I Loan-Size Limits: A Simple Model by Philip Bromiley and William E. Stansifer Most banks limit the maximum size of a loan they will make to any given customer. This limit constitutes an important constraint on commercial lending activity and deserves careful consideration. In this article, a simple way of thinking about loan-size limits, risk, and profitability is presented. This article also discusses the possi- ble eflects of loan-size limits on personnel evaluations. Any discussion of loan-size poli- cies needs to begin with some consid- eration of the objectives of the policies. Limits on loan size appear to be used to control the risk of the loan portfolio. Risk, in this sense, means the likelihood that the loan portfolio will have returns in any given year that fall below a specified level. Most of the analysis presented in this article focuses on the likelihood that a loan portfolio will have negative net earnings. However, other areas of interest include the likelihood of higher or lower levels of performance and the total variability of returns. While this article discusses the implications of loan-size policies on risk, any decisions related to loan-size © 1994 by Robert Morris Associates. Bromiley is a professor of strategic management, Curtis L. Carlson School of Management, University of Minnesota, Minneapolis, and Stansifer is a senior vice president, Norwest Corporation, Minneapolis. Professor Bromiley would like to thank Dick Wester- gaard, Duncan Sinclair, James Firnstahl, and Gerry McNamara for discussions leading to this article and for other helpful comments. 1q!

Who Makes the Decision

Abstract: All banks have rules as to who can take credit decisions. They should be clear and specify levels of authority; numbers needed to make the decision; whether authority is cumulative, pooled or individual; whether authority relates to the transaction or total exposure, and any special requirements for specific types of credit exposure. Some banks use a separate structure for counterparty — or Treasury or investment banking — credit; this chapter will deal mainly with plain lending authority, with specialised requirements for counterparty or products covered in Chapter 6.

The Allocation of Risk in Cross-Border Deposit Transactions

Abstract: Improvements in the technological infra-structure have freed financial institutions from many of the constraints of geography. Yet when courts are asked to determine liability after some event interferes with the payment of an international bank deposit, they often fall back on the notion of where the deposit is kept. This emphasis implicitly treats a bank deposit as if it is more a physical commodity at an unambiguous location where an exchange must take place, rather than as an electronic bookkeeping entry that spans national borders. The authors summarize 32 court decisions from five countries that reflect the variety of settings in which problems regarding the allocation of political risk in cross-border deposits can arise. The cases noted arose from some of the most traumatic events of the 20th century. The continuing growth in cross-border deposits suggests that conflicts over sovereign risk allocation will occur with increasing frequency. The authors note several common features of the cases: The international aspect of deposit transactions. International conflict of laws. The lack of risk allocation provisions in deposit agreements. The authors then evaluate the jumbled legal framework underlying the decisions and question whether the framework provides efficient rules for allocating political risks. Based on this analysis, the paper supports an alternative approach based on the assignment of property rights and the allocation of commercial risk. The authors argue that the distribution of commercial risks generally is efficient and that the distinction between commercial and political risks is neither useful nor definable. The advantage of adopting a commercial perspective regarding the allocation of political risks is that it affords banks and depositors greater ability to forecast the outcome of future cases. This may prevent some litigation by increasing the likelihood that parties will agree on the relative probability of the outcome in court. Moreover, it would provide a more efficient legal framework for cross-border deposit transactions.

The credit risk of complex derivatives : understanding and managing the risks of exotic options, complex swaps, warrants and other synthetic derivatives

Abstract: This book provides the tools to measure the risks and benefits of this new generation of high-tech products. For financial market professionals who must stay abreast of the latest advances in financial technology, this book is a must read. Specific products examined include: Equity derivatives; Differential swaps; Mortgage swaps; Various option spreads; Warrants.

Monetary policy and credit conditions: new evidence

Abstract: A number of recent papers seek to distinguish between "money" and "credit" theories of the transmission of monetary disturbances using asymmetric information arguments. In credit models money causes output not only through the real interest rate but also through the availability of bank credit. The research described in this paper extends the work of Kashyap, Stein and Wilcox (1993), who construct a model that incorporates a relationship benefit to bank borrowing and then test the implications of the model. In this paper I extend their work by taking into account the households' demand for commercial paper, the T- bill market and the default risk of the banking sector as a determinant of the relationship benefit.

Money Market Instruments

Abstract: This section describes briefly the main types of interest bearing assets and liabilities. It also describes the quotation conventions for the various markets. Risk managers need to know precisely how much cash they will pay and receive, and on which future dates, if they are to make informed decisions. They must therefore understand the cashflow implications of the headline rates and prices as quoted on Reuters, Telerate, Bloomberg, etc.