Showing papers on "Credit risk published in 1995"

The Effect of Credit Market Competition on Lending Relationships

Abstract: This paper provides a simple model showing that the extent of competition in credit markets is important in determining the value of lending relationships. Creditors are more likely to finance credit constrained firms when credit markets are concentrated because it is easier for these creditors to internalize the benefits of assisting the firms. The model has implications about the availability and the price of credit as firms age in different markets. The paper offers evidence for these implications from small business data. It concludes with conjectures on the costs and benefits of liberalizing financial markets, as well as the timing of such reforms.

A Simple Approach to Valuing Risky Fixed and Floating Rate Debt

Abstract: We develop a simple approach to valuing risky corporate debt that incorporates both default and interest rate risk. We use this approach to derive simple closed-form valuation expressions for fixed and floating rate debt. The model provides a number of interesting new insights about pricing and hedging corporate debt securities. For example, we find that the correlation between default risk and the interest rate has a significant effect on the properties of the credit spread. Using Moody's corporate bond yield data, we find that credit spreads are negatively related to interest rates and that durations of risky bonds depend on the correlation with interest rates. This empirical evidence is consistent with the implications of the valuation model.

Pricing Derivatives on Financial Securities Subject to Credit Risk

Abstract: This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a "spot exchange rate." Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps. THE PURPOSE OF THIS article is to provide a new theory for pricing and hedging derivative securities involving credit risk. Two sources of credit risk are identified and analyzed. The first is where the asset underlying the derivative security may default, paying off less than promised. This is the case, for example, with imbedded options on corporate debt. The second is the credit risk introduced by the writer of the derivative security, who may also default. Examples include over-the-counter writers of options on Eurodollar futures, swaps, and swaptions. For pricing derivative securities involving credit risk, there are currently two approaches. The first views these derivatives as contingent claims not on the financial securities themselves, but as "compound options" on the assets underlying the financial securities. This is the case, for example, with the pricing of imbedded options on corporate debt (see Merton (1974, 1977), Black and Cox (1976), Ho and Singer (1982), Chance (1990), and Kim, Ramaswamy, and Sundaresan (1993)) or the pricing of vulnerable options (see Johnson and Stulz (1987)). In practice, however, this valuation methodology is difficult to use. First, the assets underlying the financial security are often not tradeable and therefore their values are not observable. This makes application of the theory and estimation of the relevant parameters problematic. Second, as in the case of corporate debt, all of the other liabilities of the firm senior to the corporate debt must first (and simultaneously) be valued. This generates significant computational difficulties. As a result, this approach has not

Do Credit Markets Discipline Sovereign Borrowers? Evidence from U.S. States

Abstract: The degree to which credit markets discipline sovereign borrowers is investigated by estimating the supply curve for debt faced by U.S. states. The results generally support an optimistic view of the market discipline hypothesis, with credit markets providing incentives for sovereign borrowers to restrain borrowing. While the risk premium on bond yields is estimated to increase only gradually at low levels of debt, this effect appears to become much larger as debt rises. There is also some evidence that credit markets may withhold access to credit at very high levels of debt. Copyright 1995 by Ohio State University Press.

Method for selecting a seller's most profitable financing program

Abstract: A transaction management system and method of validating the sale of an asset. The system may be used by a vehicle dealership to evaluate a customer's credit risk, budgetary factors, and profitability of the sale during negotiations for sale of a vehicle, thereby facilitating the sale from both the customer's and dealership's point of view by properly structuring the transaction. The system enables the dealer to pool front-end and back-end profit items to maximize profits. The system performs expert functions to funnel the customer's credit information into a best fit with one of a plurality of specific finance program tiers.

Consumer Rationality and Credit Cards

Abstract: Borrowing on credit cards at high interest rates might appear irrational. However, even low transactions costs can make credit cards attractive relative to bank loans. Credit cards also provide liquidity services by allowing consumers to avoid some of the opportunity costs of holding money. The effect of alternative interest rates on the demand for card debits can explain why credit card interest rates only partially reflect changes in the cost of funds. Credit card interest rates that are inflexible relative to the cost of funds are not inconsistent with a competitive equilibrium that yields zero profits for the marginal entrant.

Default risk insurance and incomplete markets

Abstract: This paper uses the existence of secondary markets for debt instruments with default risk (e.g. corporate bonds) to define default insurance along the lines of financial economics. It examines whether, in the case of several risk-neutral measures, characteristics of default can be uniquely determined by the prices of contracts involving default-prone securities.

A Markov Model for the Term Structure of Credit Risk Spreads

Abstract: This paper provides a Markov model for the term structure of credit risk spreads. The model is based on Jarrow and Turnbull (1995) with the bankruptcy process following a discrete state space Markov chain in credit ratings. The parameters of this process are easily estimated using observable data. This model is useful for pricing and hedging corporate debt with imbedded options, for pricing and hedging OTC derivatives with counterparty risk, for pricing and hedging (foreign) government bonds subject to default risk (e.g., municipal bonds), for pricing and hedging credit derivatives, and for risk management.

Credit Bureau Policy and Sustainable Reputation Effects in Credit Markets

Abstract: Welfare-increasing reputation effects arise in credit markets when adverse selection gives rise to borrower reputation formation incentives that mitigate moral hazard problems. This paper shows that welfare stemming from reputation effects will diminish over time as the private information of borrowers is revealed to lenders in the form of lengthening credit histories. Aggregate borrower welfare may, therefore, decrease over time unless reputation effects can be sustained. Restricting a lender's access to a borrower's credit history via credit bureau policy is shown to be one method of sustaining reputation effects and preventing a decline in welfare. Copyright 1995 by The London School of Economics and Political Science.

Credit Risk Derivatives

Abstract: This article models the pricing of derivatives on credit risk, instruments proposed in 1992 by the International Swap Dealers Association that have started attracting market attention. The exact structure of the instruments continues to evolve today. We develop a framework to understand the key features of this class of products. It is shown that the price of the credit risk option is the expected forward value of a put option on a risky bond with a credit level-adjusted exercise price. Stripping of credit risk from the total risk of the bond is enabled by employing a stochastic strike price for the credit risk option. The article provides a framework for trading and hedging credit risk.

Sovereign credit ratings

Abstract: Sovereign ratings are gaining importance as more governments with greater default risk borrow in international bond markets. But while the ratings have proved useful to governments seeking market access, the difficulty of assessing sovereign risk has led to agency disagreements and public controversy over specific rating assignments. Recognizing this difficulty, the financial markets have shown some skepticism toward sovereign ratings when pricing issues.

The monetary transmission mechanism in Mexico

Abstract: An important question in macroeconomics has been how the transmission mechanism of monetary policy works. In particular, the question of whether there exists a credit channel for the transmission of monetary policy has been one of the central themes in the discussion of the effectiveness of monetary policy. If this channel exists, then shocks to credit markets, particularly to bank loans, can have real effects. This paper presents new evidence on the credit hypothesis for the case of Mexico after 1984. We present a simple variant of the open economy IS-LM model which includes a credit channel. The model has the following empirical implications which are absent from models which do not include a credit channel. We show that changes in the expectations of devaluation, the desired cash/deposit ratio, and measures of financial deregulation, will have real effects because they change the quantity of credit available in the economy. We explore these implications of the model through standard VAR techniques and find that the evidence strongly supports the credit view. We find that the impact on economic activity of credit and nominal depreciation rate shocks is very significant.

Credit crunch caused investment slump? : an empirical analysis using Finnish data

Abstract: The objective of this paper is to empirically analyze and quantify the effect of changes in the supply of bank credit on private investment.Particular interest is placed on the role of the credit crunch in explaining the collapse in private investment in the early l990s. Using a vector autoregressive econometric model, it is shown that the credit supply plays a statistically significant and economically important role in determining investment.The effect of credit on investment comes through with a lag of about a year and persists for several years.Money supply is a powerful investment predictor in a bivariate relation, but loses its significance completely once credit is included in the model.Hence, in the light of history, it appears that the money supply has had little effect on investment except as relayed through credit and, to a lesser extent, through the interest rate.On the other hand, since strong contemporaneous comovements were found between money and credit, the contemporaneous effect of money on credit may be considerable. In general, the results were found to be consistent with the credit view of the monetary transmission mechanism: monetary policy affects both sides of bank's balance sheets--money supply and credit supply--and credit seems to be the more important predictor for investment. It is estimated that positive shocks to the credit supply during 1986-1988 raised the peak for private investment in 1990 by about FIM 25 billion annually.On the other hand, the subsequent negative shocks deepened the collapse of investment by approximately FIM 20 billion annually.

Bank Risk, Capitalization and Inefficiency

Abstract: In this paper, the relation between bank risk-taking and operating efficiency is investigated in a simultaneous equations setting. While inefficiency is found to have positive effects on both credit risk and interest rate risk, it also has a positive effect on capitalization. The positive effect of inefficiency on risk-taking supports the moral hazard hypothesis that firms with poor performance are more vulnerable to risk-taking than high performance banking organizations. The positive effect of inefficiency on the level of capital is attributable to regulatory pressure on under performing firms to have more capital. Regulators prefer to discipline weak and inefficient firms by imposing higher capital requirement rather than through imposing portfolio restrictions, possibly because capital is more transparent and can be measured accurately. We also find that credit risk, interest rate risk, and capitalization seem to be jointly determined, reinforcing and compensating each other. At the same time, operating efficiency is affected by and related to bank risk-taking. Firms with more capital are found to operate more efficiently than firms with less capital, indicating that the level of capitalization is a good proxy for performance. We find mixed results regarding the effects of credit risk and interest rate risk on operating efficiency. Interestingly, a U-shaped relationship between inefficiency and loan growth rate is detected. Up to a certain point, operating efficiency improves at a decreasing rate as loan growth rate increases. This is consistent with the hypothesis that sustainable loan growth is accomplished by good management, which operates close to the efficient frontier. However, at excessive growth rate, operating efficiency decreases with loan growth. The finding supports the hypothesis that entrenched managers who pursue a growth objective to enhance their own wealth tend to operate inefficiently.

Methods of Loan Guarantee Valuation and Accounting

Abstract: Partial government guarantees of private financing can be an effective tool for maintaining public-private partnerships. Loan guarantees that cover some or all of the risk of repayment are frequently used by governments to pursue policy objectives: supporting priority infrastructure projects or corporations in financial distress. Studies show that guarantees are extremely valuable - the value of a guarantee increases with the risk of the underlying asset or credit, the size of investment, and the time to maturity. The flip side of a guarantee's value to a lender is a cost to the government. Such a cost is not explicit, but it is nevertheless real. When providing guarantees, therefore, governments must set in place risk sharing, valuation, and accounting mechanisms. This paper describes methods of guarantee valuation, reports estimates of guarantee values in different settings, and summarizes methods of guarantee accounting and their implications. While the old method recorded guarantees only when a default occured, new methods seek to anticipate losses, create reserves, and channel funds through transparent accounts to ensure that costs of guarantees are evident to decision makers. The authors use the U.S. Credit Reform Act of 1990 to illustrate accounting trends.

Enterprise finance in Zimbabwe

Abstract: This report is part of a series of studies on enterprise finance undertaken in Sub-Saharan Africa under the auspices of the multi-donor Regional Program for Enterprise Development (RPED). The report is organized as follows. Chapter one provides background information on Zimbabwe, its economic structure, and its recent history. Chapter two reviews theoretical and empirical literature in search for concepts applicable to enterprise finance in a developing country setting. The authors organize some of these concepts around the theme of contract enforcement and show how it subsumes many information asymmetries and transaction costs. The financial sector of Zimbabwe is briefly described in chapter three. Financial instruments and legal institutions are discussed and the attitude of financial institutions scrutinized. Chapter four focuses on the pattern of enterprise finance in Zimbabwe. Differences among firms in access and cost of various forms of credit are reviewed in detail. Firm size and ethnicity are shown to play an important role in access to external finance. Enforcement problems and information asymmetries are examined in chapter five. Results indicate that credit transactions are more flexible than often believed and that enforcement concerns are central to the credit screening process. They also demonstrate that Zimbabwe benefits from the existence of several overlapping reputation mechanisms that sanction contract performance. Firm growth and investment are reviewed in chapter six. Credit constraints affect firm performance in two ways by restricting their capacity to expand, and by limiting their ability to survive liquidity shocks. The authors synthesize the results at the end of chapter six by constructing a typology of firms and assessing their potential for growth and expansion. Policy implications are presented in chapter seven. Detailed policy prescriptions are derived for various categories of firms. A special emphasis is put on the promotion of indigenous enterprises.

The Term Structure of Credit Risk: Estimates and Specification Tests

Abstract: This paper examines alternative methods for making inferences about the value and dynamics of (unobserved) credit quality from market prices. Using data on Brady bonds issued by Mexico, Venezuela, and Costa Rica, we show that estimates of credit quality from of a simple model (often used by practitioners) with a constant conditional probability of default are dynamically inconsistent; the market distinguishes between current and future credit quality. We then examine two models with this feature. The first assumes that credit quality follows a diffusion process while the second assumes mean reverting dynamics for credit quality. Although these models have very different implications for the asymptotic probability of default, we show that it is impossible to distinguish between them on the basis of the few years of high frequency data in our sample. We then examine the possible consequences for the pricing of new issues that can arise from misspecification of the asymptotic probabilities.

Risk-Based Capital Standards and the Riskiness of Bank Portfolios: Credit and Factor Risks

Abstract: Bank risk-based capital (RBC) standards require banks to hold differing amounts of capital for different classes of assets, based almost entirely on a credit risk criterion. The paper provides both a theoretical and empirical framework for evaluating such standards. A model outlining a pricing methodology for loans subject to default risk is presented. The model shows that the returns on such loans are affected by the complicated interaction of the likelihood of default, the consequences of default, term structure variables, and the pricing of factor risks in the economy. When we examine whether the risk weights accurately reflect bank asset risk, we find that the weights fail even in their limited goal of correctly quantifying credit risk. For example, our findings indicate that the RBC weights overpenalize home mortgages, which have an average credit loss of 13 basis points, relative to commercial and consumer loans. The RBC rules also contain a significant bias against direct mortgages relative to mortgage- backed securities. In addition, we find large differences in the credit riskiness of loans within the 100 percent weight class and potentially large benefits to loan diversification, neither of which are considered in the RBC regulations. We also examine other types of bank risk by estimating a simple factor model that decomposes loan risk into term structure, default, and market risk. One implication of our findings is that although banks have reallocated their portfolios in ways intended by the RBC standards, they may have merely substituted one type of risk (term structure risk) for others (default and market risk), of which the net effect is unknown.

The effect of merger and acquisition activity on the safety and soundness of a banking system

Abstract: The purpose of this paper is twofold. First, it argues that merger and acquisition activity reduces the total risk in the banking system. Second, it suggests that the recent high level of merger and acquisition activity as well as the high rate of banks failure is an adjustment process of a banking system to a smaller optimal size.

A Prolegomenon to Future Capital Requirements

Abstract: Since the early 1980s, bank supervisors have made significant strides with regard to capital requirements. The last fundamental change in the United States followed the 1988 Basle Accord, which contained explicit requirements for off-balance-sheet positions as well as more conventional standards based on the balance sheet. At present, supervisors are contemplating further steps in the refinement of capital requirements. They are considering, among other issues, explicit requirements for market risk, including the use of banks' own risk management models for capital requirement purposes, as well as possible longer run strategies for handling risks other than credit quality and price.(1) If we assume that the current market risk proposal is successfully implemented, where do we turn next? More generally, what are the long-range goals of capital supervision? This article is intended as a preliminary step--a prolegomenon--in addressing these long-term issues.(2) The object of the article is to persuade those who think that capital requirements are worth studying that it is important to pause a moment and, abstracting from all that has been done, to delineate a set of fundamental principles for future work on capital requirements. It seems important, at least from time to time, to expand the focus of the analysis of bank capital. If only narrow technical questions were ever posed, it would be difficult to address the broader issues with a satisfactory level of confidence in the results. Thus, the methodology of this article is somewhat unusual in the context of standard economics. The approach is empirical and deductive, but is not based explicitly on hypothetical microeconomic modeling, which is readily available elsewhere.(3) Instead, this article identifies the useful features of capital requirements, past and present, as a means of establishing criteria that we would find desirable in subsequent capital regimes. As a helpful preliminary, we first draw a distinction between regulatory capital requirements (minimum capital) and the internal risk management and capital allocation of the firms (optimum capital). Although the two areas overlap in methodology and terminology, they differ greatly as to their goals. Failure to recognize this distinction can lead to unnecessary confusion and has the potential to make capital requirements less useful and institutions' risk management less effective. This article does not address specific capital proposals nor does it suggest specific new requirements. The framework it provides, however, has implications for possible future refinements in the supervisory approach to capital requirements. MINIMUM CAPITAL This section defines the concept and the goals of regulatory capital requirements through inherently empirical means. It proposes to identify from past and present capital rules the specific characteristics that have made those rules useful to their intended audiences. These characteristics may then be construed as goals for future minimum requirements. In very broad terms, capital requirements consist of three basic components: a definition of capital, a measure of the exposure to risk that capital is intended to cover, and a required relationship between those two amounts (typically a minimum ratio). Consider the components in slightly greater detail. Regulatory capital is defined to include those claims on the value of the firm that are first in line to absorb future losses arising from a broad range of contingencies. Such contingencies correspond generally to the notions of credit risk, price risk, model risk, operational risk, liquidity risk, legal risk, and so forth. Typical examples of capital instruments are equity--the best form of capital--and subordinated debt--which requires an event of default for losses to be absorbed. The primary purpose of these layers of capital is to protect the senior creditors of the firm, especially the depositors in the case of banks. …

Bank Credit Risk Management

Abstract: Bank management, from a finance theory perspective, is generally acknowledged to involve the management of four major balance sheet risks: liquidity risk, interest rate risk, capital risk and credit risk (Hempel et al, 1989). Of these, credit risk has commonly been identified as the key risk in terms of its influence on bank performance (Sinkey, 1992, p.279) and bank failure (Spadaford, 1988).

Bank Risk, Capitalization, and Operating Efficiency

Abstract: In this paper, the relation between bank risk-taking and operating efficiency is investigated in a simultaneous equations setting. While inefficiency is found to have positive effects on both credit risk and interest rate risk, it also has a positive effect on capitalization. The positive effect of inefficiency on risk-taking supports the moral hazard hypothesis that firms with poor performance are more vulnerable to risk-taking than high performance banking organizations. The positive effect of inefficiency on the level of capital is attributable to regulatory pressure on under performing firms to have more capital. Regulators prefer to discipline weak and inefficient firms by imposing higher capital requirement rather than through imposing portfolio restrictions, possibly because capital is more transparent and can be measured accurately. We also find that credit risk, interest rate risk, and capitalization seem to be jointly determined, reinforcing and compensating each other. At the same time, operating efficiency is affected by and related to bank risk-taking. Firms with more capital are found to operate more efficiently than firms with less capital, indicating that the level of capitalization is a good proxy for performance. We find mixed results regarding the effects of credit risk and interest rate risk on operating efficiency. Interestingly, a U-shaped relationship between inefficiency and loan growth rate is detected. Up to a certain point, operating efficiency improves at a decreasing rate as loan growth rate increases. This is consistent with the hypothesis that sustainable loan growth is accomplished by good management, which operates close to the efficient frontier. However, at excessive growth rate, operating efficiency decreases with loan growth. The finding supports the hypothesis that entrenched managers who pursue a growth objective to enhance their own wealth tend to operate inefficiently.

Government Credit Policy and Industrial Performance (Japanese Machine Tool Producers, 1963-91)

Abstract: Programs to direct credit to industry can be uniquely beneficial if 1) the purpose of government credit is to relax borrowing constraints on firms, as an end in itself, or (2) other government objectives can best be achieved by relaxing firms' borrowing constraints (in which case, product and factor market externalities motivate government credit programs). According to Japanese officials, government involvement is warranted when: 1) investment risk is too high for a particular activity (because it is too large-scale or high-tech, or needs long gestation and market development); 2) there is a big discrepancy between private and social benefits when industries or parts of industries may save foreign exchange, for example, and thus relieve the balance of payments constraint on other growth industries); 3) information problems discourage lending to small and medium-scale industries; 4) infant industries face large social set-up costs. The authors examine the effect of policy-based finance for the period 1963-91 for Japan's machine tool industry, an industry with high potential spillover effects on technological innovation and learning. They found that directed credit may have helped to promote investment among postwar Japanese machine tool producers. Important components of that credit seem to have spurred growth. The government credit programs did not crowd out private funds and did not succeed by providing a permanent lifeline (credit insurance) to firms. But the authors do not endorse government interventions in credit markets. For one thing, the effective operation of industrial directed credit in Japan seems to be an unrepresentative case. In many countries, such government intervention has produced large costs: inefficient borrowers have been funded and public funds have been captured by special interests. In Japan, directed-credit policy is designed to promote investment, crowd in private funds, and avoid the capture of policy funds by particular firms or industries. The priorities of credit policy are determined as part of a national plan with broad participation (rather than by special-interest lobbying), and once industry-level priorities have been established, firm-level lending decisions by agencies are shielded from political pressure. In political systems that cannot implement such effective plans for distributing industrial credit, government-directed credit programs may create more problems than they solve.