Optimal Credit Limit Management Under Different Information Regimes

by Markus Leippold of the University of Zürich,
Paolo Vanini of the Swiss Banking Institute, University of Zürich & Zürcher Kantonalbank, and
Silvan Ebnoether of Zürcher Kantonalbank

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.

JEL Classification: G18, C19, G21, C69.

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

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