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A Theory of Monitoring Credit Risk

by Douglas Dwyer of the Moody's Analytics

April 2011

Abstract: On any given day, credit analysts monitor multiple names. Some names will have been reviewed recently, but not all. Some names are easily traded out of, while some names are more difficult to hedge. Some names represent large exposures while others represent small. Some are known high credit risks while others are low credit risks. The risk profile of some exposures may have changed recently while others remained unchanged. How to triage? Which names should the analyst review first? Next? Ultimately, how does the institution value a credit review? This paper derives an optimal monitoring strategy, under the assumption that there is a fixed cost for reviewing a loan. The framework can be embedded within a dynamic competitive equilibrium in which prices reflect public information. We calibrate the framework using parameter values with empirical interpretations. In the dynamic setting, we show that in specific circumstances, a "mid-year" review can produce incremental value equal to 1.3% of the exposure size.

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