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Risk management and Decisions.

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Introduction

In the credit market, the major problem is the risk of lending, which mainly refers to asymmetric information. From some points, as Besanko and Thakor and Bester argued borrower knows more than the lender, because the bulk of private information, such as details of investment on projects, resides with the borrower and the lender must somehow devise a way to predict whether the borrower is going to meet her repayments( Lecture notes). But from some aspects, argued by Meza and Southey et al., the lender knows more than the borrower because bank has great amounts of information that it has collected over the lifetime of the borrower and the lifetime of similar borrowers, thus it can calculate the probability that the borrower will default better than the borrower (Lecture notes). For the banks, they normally reduce the risk by examining two angles of information, which are private and public. Therefore, the fact of that small business looking for a first time loan with a new bank lender is perceived as higher risk than a business who wishes to refinance with its existing lender can be also explained in these two aspects. Firstly, this bank wants to develop private information from both of them. The main tool will be the pre-existing relationship with potential lender, which is identifies as the proxy for private information by Cole who found that pre-existing relationship generate valuable private information. This can be also supported Berger and Undelll (cited in Cole) and Petersen and Rajan (cited in Cole) and Hanley, who all have examined the importance of the pre-existing relationship. ...read more.

Middle

(cited in Storey) in their study of US manufacturing plants showed that the average failure rate for the plants with between five and nineteen employs was 104.7 per cent higher than for plants with more than 250 employees. Back to those two firms in question, it is obvious that the existing firm is expected to have higher total asset and sales and more employees than the new and small firm. Due to the highly competitive credit market, banks still consider to grant loans to some small and new businesses although the probability is much lower than existing and large firms. In order to reduce the risk, the bank normally requires collaterals in this case. Cressy and Toivanen (cited in Hanley) found there is a trade-off between the collateral and interest margin using standard regression and 2SLS. Berger and Udell (cited in Hanley) also report a trade-off between collateral and margins for the commitment loans in their sample. Consistent with the descriptive statistics in Hanley's research, the higher the value of collateral provided, the lower the rejection probability, as indicated by the negatively signed coefficient. This result confirms evidence from Basu and Parker (2001) (cited in Hanley) that the main reason of the rejection of application is the lack of security. Therefore, it is suggest that increasing the collaterals can increase the probability of receiving loans for the small business which require for the first time loan. However, argued by Joseph Stiglitz and Andrew Weiss( cited in Bester), this situation might lead to a problem called adverse selection, which means better borrowers drop out of the ...read more.

Conclusion

Secondly, the organizational form is one of the factors because the degree of informational asymmetry may vary with organizational form, as the agency conflicts between owners, managers and creditors(Cole,1998) Indeed, higher growth is associated with higher rejection probability because excessive early growth drains the enterprise of cash flow, thereby might cause entrepreneur default on his repayment(Cole, 1998) Furthermore, Hanley (2003) also found that the firm characteristics affect the decision deny credit. More sanguine entrepreneurs, who see no risks that would disturb their business projects, are more likely to receive credit than pessimistic entrepreneurs. Finally, the bank prefers lending to business can operate in the absence of the principal owner, as evidenced by the higher proportion (73 percent) of applicants in the group who receive finance (Hanley, 2003). To sum up, the small business applies for fist loan is recognised as higher risk are mainly based on three factors, which are the zero length of pre-existing relationship, zero firm age and small firm size. In order to increasing the probability of success, this new firm can choose either providing higher value collaterals or require small amount of loans. Although the firm that want to refinance with existing lender is expected to benefit from easy access of loans and lower interest margins, it needs to consider the existence of hold-up problem. In fact, we fin that some other factors, which can prove that the small and new firms are not always riskier than the existing firms, are not been investigated by banks. Therefore, it is suggested that banks should do more investigation and hence will be fairer to small and new firms. ...read more.

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