Question

Explain why each of the statements below is True, False or Uncertain.

a. Compensating balances kept at the bank that has originated a loan help to reduce the adverse selection and moral hazard problems associated with lending.

b. If the book value of the collateral is greater than or equal to the amount of the loan, the credit risk of the lender is fully covered.

c. The market risk premium positively depends on the probability of default of the borrower and the recovery rate.

Answer 1

a. Since the investors are likely to choose high risk investment once they have a loan, banks face a moral hazard problem. Also, borrowers with riskier projects ( higher probability of default) are likely to approach bank for a loan than borrowers with safer projects, banks also face a adverse selection problem. To counter this, banks manitain a compensating balance ( minimum bank balance needed for a business loan) which ensures that the borrowers make more prudent decisions as the irrationality would be curbed by the loss aversion fear of the compensating balance in case of a default. Hence, compensating balances would reduce adverse selection & moral hazard. TRUE

b. Since the book value of the collateral is greater than or equal amount of loan, in case of a default, the lender can sell the collateral at the book value to recover the entire payment shortfall by the borrower.

Since, collateral value >= Debt Value

and Max. shortfall = Debt Value ( since, one cannot lose more than what once lends)

==> Collateral value >= Max. shortfall

Since, there is no possibility of capital loss in this case, the credit risk is completely covered.

TRUE

3. Market Risk premium is the additional rate of return demanded by investors over risk free rate to incentivize investment into a risky loan. As the probability of default is borrower goes higher, the possibility of lower payout is grater, hence higher risk which means investors demand higher return. This implies that the rate of return demanded goes up, which pushes market risk premium higher.

Recovery Rate is the percentage of the debt recoverable from a defaulter. Higher the recovery rate, higher would be the debt amount recoverable, which increases the expected payout, which make the loan more safer meaining, market risk premium actually recudes market risk premium.

Hence, the market risk premium is positively related to default of borrower and negatively related to recovery rate. FALSE