9.4 Credit Risk #Notebook

 9.4 Credit Risk #Notebook

Financial intermediaries use the application only as a starting point. Typically do two things:

I. Make the application a binding part of the financial contract.

II. Verify the information with disinterested third parties. Financial intermediaries can also buy credit reports from professional report providers like Equifax, Experian, and Trans Union.

Insurance companies regularly share information with each other so that risky applicants can’t take advantage of them easily.

To improve the screening acumen, many financial intermediaries specialize by making loans to only one or a few types of borrowers, by insuring automobiles in a handful of states.

Specialization also helps to keep monitoring costs to a minimum. To reduce moral hazard, intermediaries have to pay attention to what borrowers and people who are insured do and know what sort of restrictive covenants (aka loan covenants) to build into their contracts. 

Loan covenants include the types of information to be provided in reports, inspections, limitations on account withdrawals. Insurance companies also build covenants into their contracts and investigate claims that seem fishy to reduce moral hazard.

However, specialization has its costs. Issuing too many policies, or making too many loans will lead to overspecialize and hurting their asset management.

Forging long-term relationships with customers can help financial intermediaries to manage their credit risks such as lending with better assurance.

One way that lenders create long-term relationships with businesses is by providing loan commitments, promises to lend $x at y interest for z years, arrangements called lines of credit.

Bankers also often insist on collateral, assets pledged by the borrower for repayment of a loan, the collateral is called compensating or compensatory balances. 

Credit rationing is another tool to combat asymmetric information.

However, in 2007–2008, banks and other lenders are not perfect screeners, under competitive pressure, they lend to borrowers they should not have. 

External political or societal pressures induce bankers to make loans they normally wouldn’t. Such excesses are always reversed eventually because the lenders suffer from high levels of non-performing loans.

In the crisis of 2007, why didn’t the government immediately intervene by guaranteeing the subprime mortgages?

Directly bailing out the subprime lenders by guaranteeing mortgage payments would cause moral hazard to skyrocket, because the borrowers might be more likely to default by rationalizing that the crime is a victimless one and the lenders would learn that they can make crazy loans to anyone because Uncle Sam(=The US government) will prevent their fall.

Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.