Optimal Credit Limit Management Under Different Information Regimes
29 Pages Posted: 12 Oct 2003
Date Written: February 2005
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.
Keywords: Credit risk management, optimal limit policy, partial information, adverse selection
JEL Classification: G18, C19, G21, C69
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