Working Paper: CEPR ID: DP3686
Authors: Roman Inderst; Holger M. Müller
Abstract: 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.
Keywords: banking; credit decision; credit risk analysis; security design
JEL Codes: G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| subjective judgment in evaluating borrowers (G21) | incentive problem for lenders (G21) |
| lender's claims influence credit decisions (G21) | lenders are overly conservative (G21) |
| lack of alignment between lender's incentives and overall project value (G33) | flawed credit decisions (G51) |
| debt leads to less conservative lending practices (G21) | increasing likelihood of project acceptance (H43) |
| unique optimal security (standard debt) (H63) | minimizes lender's tendency to overweight type 1 errors (G21) |