Economics, Econometrics and Finance
4 years ago

New technique reveals true credit risk in banks' loan portfolios!

SSRN Electronic Journal
How Bad is a Bad Loan? Distinguishing Inherent Credit Risk from Inefficient Lending (Does the Capital Market Price this Difference?)
Joseph P. Hughes, Choon-Geol Moon

Paper Summary

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The article introduces a new method to break down banks' bad loan ratios into three parts: the ideal ratio based on good lending practices, the difference between the actual ratio and the ideal ratio, and statistical noise. The ideal ratio shows the inherent credit risk of the loan portfolio if the bank was fully efficient at evaluating risks. This helps to distinguish between the natural risk of loans and the bank's skill in making loans.