Managing credit risk and interest risk

Adverse selection in loan markets occurs because bad credit risks (those most likely to default on their loans) are the ones who usually line up for loans; that is, those who are most likely to produce an adverse outcome are the most likely to be selected.

Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders' point of view.

Ways to prevent the above two problems:
(1) Screening and monitoring:
Lenders should screen out the bad credit risks from the good ones so that loans are profitable to them.
Information collection

Specialization in some market loans makes banks easier to collect relative information

(2) Long-term customer relationships
(3) Loan commitments:
a loan commitment is a bank's commitment (for a special future period of time) to provide a firm with loans up to given amount at an interest that is tied to some market interest rate.
(4) Collateral and compensating balances:
a firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank
(5) Credit rationing:
Lenders refuse to make loans even though borrowers are willing to pay the state interest rate or even a higher rate.
Two forms
(a) a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate
(b) a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like

Managing interest risk:
If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits.

We can use gap analysis (in which the amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets) to measure the sensitivity of bank profits to changes in interest rates

Duration analysis: examines the the sensitivity of the market value of the bank's total assets and liabilities to changes in interest rates.
% change in market value of security = -% change in interest rate * duration in yrs