Banking and the Management of Financial Institutions - Managing Credit Risk
10 important questions on Banking and the Management of Financial Institutions - Managing Credit Risk
How do you make successful loans?
Principles that financial institutions must follow to reduce credit risk (to overcome Adverse Selection and Moral Hazard):
• Long-Term Customer Relationships
• Loan Commitments
• Collateral and Compensating Balances
• Credit Rationing
What is specialisation in lending?
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What is monitoring and enforcement of restrictive covenants?
Why is long-term customer relationship important?
- Information about the liquidity
- Record of past loan payments
- Easier for the client to obtain a loan at a lower interest rate
What are loan commitments?
What are the benefits of loan commitment?
• Firm has source of credit when it needs it
• Bank receives a lot of information about the client (income, asset and liability position, …)
What are collateral and compensating balances?
Property promised to the lender as compensation if the borrower defaults to reduce the risk of adverse selection and moral hazard
• Compensating balances:
A firm receiving a loan must keep a required minimum amount of funds in an account at the bank
Why does a lender refuse to make a loan of any amount to the borrower, even if the
borrower is willing to pay a higher interest rate
Why is the lender willing to make a loan but restricts the size of the loan to less than
the borrower would like
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