Optimal Credit Limit Management Under Different Information Regimes
by Markus Leippold of the University of Zürich,
February 27, 2005
Abstract: Credit limit management is of paramount importance for successful short-term credit-risk management, even more so when the situation in credit and financial markets is tense. We consider a continuous-time model where the credit provider and the credit taker interact within a game-theoretic framework under different information structures. The model with complete information provides decision-theoretic insights into the problem of optimal limit policies and motivates more complicated information structures. Moving to a partial information setup, incentive distortions emerge that are not in the bank's interest. We discuss how these distortions can effectively be reduced by an incentive-compatible contract. Finally, we provide some practical implications of our theoretical results.
Keywords: Credit risk management, optimal limit policy, partial information, adverse selection.
Published in: Journal of Banking & Finance, Vol. 30, No. 2, (February 2006). pp. 463-487.
Previously titled: Optimal Credit Limit Management