Journal of Applied Finance & Banking

Credit risk based on firm conduct-performance and bank lending decisions: A capped call approach

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  • Abstract

    This paper models loan rate-setting behavior, taking into account the product pricing and performance of the borrowing firm, and also calculates the bankís loan-risk sensitive equity values. The lending function creates the need to model bank equity as a capped call option, which captures the credit risk directly related to management of a firmís operations. When the product price set by the borrowing firm is relatively high and the loan rate set by the bank is relatively low, a rise in the product price increases the loan amount at a reduced margin. A capped call as such makes the bank less prudent and more prone to risk-taking, thereby adversely affecting the stability of the banking system. We also show that the market-based estimates of bank equity, which ignore the cap, lead to significant overestimation.