DP3686 | Credit Risk Analysis and Security Design

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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 off type-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.