Risk management: Ways to manage credit risk

Asymmetric information may be the reason for credit risk. Managing credit risk includes:

  • Screening: screening out bad credit risks before loans are made. To screen out bad credit risks, financial intermediaries typically need to collect financial information about potential borrowers before the transaction.

 

  • Specialization: knowledge of particular credit markets and knowledge about particular borrowers.

 

  • Monitoring: after the transaction, the lender monitors the activities of the borrower to be sure he is not engaging in risky activities.

 

  • Enforcement of covenants: after the transaction, the lender requires that the borrower satisfy covenants in the loan contract to ensure he does not engage in risky activities. Solving asymmetric information problems: managing credit risk

 

  • Long term relationships: provides information for the lender to assess the problems of adverse selection and moral hazard

 

  • Loan commitments: commitment to provide future loans in return for financial information about the borrower’s financial well-being. –helps promote long term relationships and better information about borrowers.

 

  • Collateral and compensating balances: helps reduce adverse selection moral hazard problems (example: mortgages where home is collateral) Solving asymmetric information problems: managing credit risk

 

  • Credit rationing: refusing to lend to borrowers even though they are willing to borrow. – restriction of size of loans: reduces moral hazard problems. The larger the loan, the greater the incentives to engage in activities that make it less likely that borrower will repay. – refusal to lend any amount to certain borrowers: reduces adverse selection problems. Higher interest rates only attract people with greater credit risk.

 

 

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