CHAPTER TWO: LITERATURE REVIEW
This chapter reviews the body of literature on the subject matter
of Problem Loans, and it is
sub-divided into five parts:
· Part one: It mentions some links between the reality of
problem loans and basic economic theories such as asymmetrical information,
adverse selection, moral hazard and early warning systems.
· Part two: This provides some country by country insights
by looking at bank crises faced
by Japanese, Chinese and Latin America banks and learn lessons
from them.
· Part three: This part shows the role played by
supervisors and external auditors in identifying problem loans.
· Part four: The focus is on identifying the defining
features of global acceptable practices
for managing problem loans.
· Part four: In this final part, the literature
review distills a core of recommendations as constituting the framework
of best practices.
I. Basic theoretical framework
1. Problem loans and asymmetrical
information
Although the problem of economics of information and the
special issue of asymmetric
information was debated by early economists such as
Adam Smith (1776), Simonde de Simondi (1814), John Stuart Mill (1848),
Alfred Marshall (1890) and Max Weber (1925), they did not mention
the term «asymmetrical information». The most famous paper on
the topic was «The market of lemons» of Akerlof (1970). In
this study, Akerlof notes that the owner of a «lemon» (used car)
knows more about its quality than any potential buyers. The example of used
cars therefore involves asymmetric information. According to Akerlof,
asymmetric information exists when one side of the market possesses information
lacked by
others players in that market. Other authors referred to
other markets in which asymmetric
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information operates. Spence (1973) applied information
asymmetry to the labour market, stating that a job applicant knows more
about his skills than the employer. Another example relates to an insurance
company with a relatively inadequate knowledge about a potential
client's health. Stiglitz and Weiss (1981) are those who emphasized
on credit rationing as consequence of asymmetric information. For them there
is asymmetrical information between banks being the less-informed
principals and borrowers being the well-informed agents, referring to the
agency theory developed by Jensen and Meckling (1976). This model is quite
similar to the theoretical one of Jaffee and Russell (1976) in which
imperfect information about the investment to be made leads to credit
rationing in a loan market in which lenders are less informed than borrowers on
the likelihood of default and the riskiness of the investment. This last
example leads to the fear for the loan to become bad and the banker not to
recover
the principal and interest of the money lent. The
Minsky theory of investment finance and financial instability model
illustrates that as well. Minsky (1982, 1985) assumes that bank
financing is needed in an investment project and the decision of
investment is made under uncertainty. Once the decision to invest is taken
and the project financed, the principal and the interest are supposed to be
repaid with the expected revenues of the investment. If then an external shock
occurs, the recovering of the bank financing becomes doubtful and the loan
becomes bad.
Asymmetric information between the bank (as lender) and the
investor (as borrower) about
the actual characteristics of the investment being
made, coupled with the instability of the market and global environment
lead to problem loans management. Therefore, an effect on both factors is
supposed to overcome problem loans. Assuming the hypothesis of the
efficiency of the market, the only significant factor worth
considering is information asymmetry. This leads us to adverse
selection and moral hazard, both consequences of the attempt to overcome
information asymmetry.
2. Problem loans, adverse selection and moral hazard
«The market of lemons» contains both good and bad
quality used cars and Akerlof shows that
the awareness of potential borrowers will lead them to
assume that the percentage of bad quality used cars is high. That will
depress the price of used cars in general and drive good quality used cars out
of the market. This phenomenon is defined by him as adverse selection.
In the Stiglitz and Weiss model, prices can act as a
screening device to distinguish bad
borrowers from good ones in the same market. According to them
raising the interest rate can
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help select good borrowers but only up to a certain limit of
interest rate r* (figure 1). Above that interest rate, the adverse selection
operates and the market starts attracting bad borrowers with high risk. Another
effect of using interest rate as screening device is that at high interest
rates, borrowers are more likely to change their behavior and invest in high
risk projects (with high expected returns). That change in the behavior is
known as moral hazard.
Figure 1: Bank optimal rate
Source: Credit Rationing in
Markets with Imperfect Information,
Stiglitz and Weiss (1981)
Williamson (1986) developed a model of credit rationing
where borrowers are subject to a moral hazard problem. In his model some
borrowers receive loans and others do not.
In the same vein, according to Claus and Grimes
(2003) adverse selection increases the likelihood that loans will be
made to bad credit risks, while moral hazard lowers the probability
that a loan will be repaid. Their model of credit rationing to avoid problem
loans
is slightly different from Williamson's one. They identify two
forms of credit rationing. The first is to give some applicants a smaller loan
than they applied for at a given interest rate. The second is not to give other
applicant a loan at all even if they offered to pay a higher interest rate.
Edelberg (2004) studied tested adverse selection and moral hazard in
consumer loan
markets. She found evidence of adverse selection, with borrowers
self-selecting into contracts
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with varying interest rates and collateral requirements.
She also found evidence of moral hazard such that collateral was used to
induce a borrower's effort to repay their debts. Her conclusion was that loans
terms had a feedback effect on behavior.
The efforts to solve the problem of asymmetric information
lead authors to adverse selection and moral hazard, both factors that higher
the probability to face a problem loan. Interest rate appears to be inefficient
in selecting good borrowers from bad ones as well as all other loan terms such
as collaterals. Is the optimal contract between a lender and a
borrower a debt contract in which the lender only monitors in the
event of default as concluded by Williamson? We do not think so
because the lender's concern is to prevent from problem loans and not
to support it.
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