Debt investments and its taсtiсs

Title: 

Debt investments and its taсtiсs

Author: Vladimir N. Khrapko

Lending to enterprises in cases of incomplete information about their investment prospects remains an increasingly important issue for financial institutions, particularly for banks. The issue is vital during crises or recession as at such periods the situation is getting worse with credit and other investment resources. Using the methodology of contract theory, the article formulates the problem of loan optimization with due regard to the type of borrower and to a lender's access to the information about each type. When all types of borrower are identified, a creditor may conclude an effective contract with either type. Technically, such contracts are described by two components: a loan volume C issued by a bank and the amount of loan repayment D, which is usually larger than C. The bank profit P is measured as the difference between the return of a payment D and the credit C. In the case of two different types of borrowers, the bank will be able to secure the optimal lending on average. The proposed method enables the lending bank to choose tactics that would provide the best profit. The model calculations were made for two situations. In the first situation, the market is homogeneous
and  the bank faces only one type of borrower. Under these circumstances, the model calculations show that the increase of borrowers leads to an increase in the bank's profitability. In the second situation, the market of borrowers is heterogeneous and is presented by two types of borrowers, although the bank does not have appropriate information about them. As it follows from the four variants of the second situation, the most favorable variant is the contract with two options for the two types with no self-selection requirement. If a self-selection requirement
is added to the optimization, the bank's profit is significantly reduced.