FIN-02-059 |
NYU Stern School of Business |
November 2002
Roman Inderst and Holger M. Mueller
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 otype-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.
Roman Inderst
Institution: Department of Economics & Department of Accounting and Finance, London School of Economics, Houghton Street, London WC2A 2AE.
Email: r.inderst@lse.ac.uk
Holger H. Mueller
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0279
Fax: (212) 995-4233
Email: hmueller@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~hmueller
To download a copy of this paper click here
To request a copy of this paper click here
|