Market mechanism, lending and risk

On  December 14, 2013,  Mamun Rashid wrote an article in the Financial Express that dealt with loan defaults, risks in lending, and offered some suggestions how to deal with such issues in a more judicious way. He mentioned some factors that cause loans to go bad:  (1) weak need assessment, (2) wrong structuring of facilities, (3) collateral shortfall, (4) lending on the basis of names, (5) ignorance about competition, and (6) investment in business other than core ones. He also argued that in case of collateral shortfall and inadequate internal cash generation pricing should be done in such a way that it reflects the inherent risk.  We rather argue that this is not the rational strategy of a rational actor because lending is not like selling oranges or potatoes in the market. A person who runs the risk of seasonal fluctuations of demand for his product can set price in such way that his risk is incorporated in the price, but a lender who runs the risk of shortfall of collateral can hardly do that and even if he does so, it is less likely that he will be able to maximise his return from his lending.  To understand this dichotomy, we need to know very well why market mechanism in case of lending differs from ordinary market mechanism and how risks component evolves from lending.
RISK AND CLASSIFICATION: In broader terms, risk can be classified into the following two categories: Market risk and Frictional risk. Market risk evolves from the market itself; mostly from the improper application of the rules of market mechanism. Frictional risks arise from the lack of discretion, lack of foresight, and errors of judgment etc. Now, we can see that the factors mentioned by Mamun Rashid falls into these two categories but mostly in the latter one. The rational expectation is that if the market risk is taken care of, then most of the risks will vanish and frictional risk will not be a big problem for one organisation. Now, the question is how to get rid of market risk? The answer is using the discretionary rules. Let us see what the discretionary rules are.
A SIMPLE HYPOTHETICAL CASE: Assume that there is a person who sells only oranges. He sells oranges either in cash or credit. He knows perfectly how to react when market overshoots or undershoots; that means when demand increases and demand decreases. Say that this time he has seen a sudden increase in the demand for oranges. As a seller he will not only try to sell more but also charge more since higher demand implies higher price. So, he can increase the price without any trouble on the condition that other things remain constant. Now, assume that the same seller sells oranges in credit; he in fact gives loan to buyers in terms of oranges expecting the repayment at some later date including some extra  for the time elapsed. Now what this person should do when he sees that demand has increased? Should he respond to the situation increasing the price as he did before? If he is a rational and profit maximising lender, then he will not do so because his credit sale has two vital characteristics: (a) lack of simultaneity of return and (b) risk component evolving from the time lag between sales and receipt of sales. He can't sell his oranges by simply reacting to market demand when he is selling in credit. If he does so, then the likely result is that he will be trapped in a situation in which he will sell his product to the highest bidders who are most likely to be the prospective defaulters. The prominent characteristics of defaulter are that they often bid the highest price and cheat after availing the advantage from the situation. Now the seller can adopt this strategy of selling his oranges. He can fix his price at some level and will not increase the price no matter how much higher the demand is. This strategy can be called 'defaulters driving out strategy'.  If we depict the above analysis in the two dimensional graphical view, we can see the following picture:

In the above figure, demand and supply (S, D) are measured on the horizontal axis and price on the vertical axis. The seller will normally sell at the price p* at which his supply is equal to the demand. Now if the demand increases and demand curve shifts to D1, he will raise the price and sell more. This happens when he sells in cash not in credit. But if he sells in credit and raises the price to P0, it is highly likely that lot of defaulters will bid higher price to deceive him and he will be trapped in such deception. Why they do so? Well, this is the incentive they get when transactions happens in credit. Paying out of their wallet now and paying out of their wallet in future matter a lot because it is easy to give promise without having any intention of keeping that promise while it is not easy to buy a thing in cash since budget constraint will force them to bid a rational price that is within your budget. But for future, budget constraint almost doesn't exist at present time and this induces to bid higher price.  That's why we have shaded the region as a defaulter's region. But the seller can escape such deception if he fixes the price and the supply of oranges at some level without responding to higher demand and higher pricing rule. So, the seller will fix the price at P* and the supply at S*. This straightforward lesson is very critical for the whole finance discipline because not only financial theorists and practitioners  but also other academicians have failed to understand why ordinary demand and supply mechanism doesn't work properly in banking sector. Therefore, the essence is that higher demand and higher price and higher risk and higher price are not a rational rule at all and they are
simply irrelevant and contradictory to return maximising objective of banks.
Now, we can assess why we said that the claim made by Mamun Rashid is not risk minimising. The exact explanation is that higher risk and higher price doesn't at all eliminate risk for banks. In fact, this policy is the real culprit of generating risks for banks. The hidden and cruel truth is that risk offsetting mechanism by charging higher price by banks traps them in a vicious circle of risks and default risk is one of them. The proverb "no risk no gain" is just a half truth in economics and fully a misguided teaching for financial institutions.
RISK AND LENDING: A TIME VIEW OF RISK: The orange selling example shows when the seller sells his oranges in cash, his return is always  certain, but when he sells his oranges in credit, his return becomes somewhat uncertain because today's return from selling is equal to the expected return of tomorrow. That means risk evolves from the lack of simultaneity of transaction. Cash sales are simultaneous and instantaneous and the seller needn't wait for anytime. As soon as he sells, he receives his proceeds from sales. But credit sales are not simultaneous, and the sellers get, instead, his proceeds some days after his sales. If we translate this in the simple language of mathematics, we see that:

If we plot this in graphical form, we see the following picture:  

In the figure A, we have measured the buyer's and borrower's return on the horizontal axis and seller's and lender's return on the vertical axis at different time.  We see that two straight lines originate from the origin and we have named one as seller's return curve and another is lender's return curve. seller's return curve shows that return of seller and buyer is simultaneous in time; that means buyer's return at time t is equal to seller's return at time t; buyer's return at time t+1 is seller's return at time t+1 and so on. On the other hand, when oranges are sold in credit, lender's return at time t is the expected value of borrower's return at time t+1; lender's return at time t+1 is the expected return of borrower's return at time t+2 and so on. Because of simultaneity of time, seller's return curve is 45 degree inclined, but lender's is less than 45 degree inclined due to the lack of simultaneity. This is shown in the figure B. The shaded region between the two curves is the measure of pure market risk. The main theme of such time perspective of risk is why ordinary market mechanism is not applicable to lending. For example, if one applies the rule such as higher risk means higher price, then the result might be default problem since the return itself is not simultaneous, and the time lag between lending and receipt of proceeds from lending implies that lending market is characteristically different from the ordinary selling of oranges in market.  Now, if we plot the two equations in graphical term, we find the following picture:

In the above figure, buyer's and borrower's return are measured on the horizontal axis and seller's and lender's on the vertical axis. It shows that to get rid of loss, return of the borrower must be R0 otherwise, the lender will face loss. Whys is this? The reason is that the negative constant co-efficient term indicates some probabilistic value which in fact shows that higher risk and higher return policy will trap banks often in big trouble. More precisely, this constant term is the critical risk factor for banks because if banks ignore it and follow the higher price and higher risk policy, it becomes highly likely that banks will get negative return.
MARKET RISK ELIMINATION AND DISCRETIONARY RULES: Both types of risk - market and frictional - can be significantly reduced using discretionary rules. But if we become able to reduce market risks, frictional risks will not be a big problem. It should be mentioned that frictional risks are often created by market risk as well. Therefore, in brief, we sum up the following discretionary rules to reduce market risks. (1) Banks should always remember that market mechanism for lending is different from the ordinary market mechanism.
The conventional rules such as higher demand and higher price and higher risk and higher price are not compatible with return maximisation objective of banks. In fact, these rules often trap banks in troubles. (2) Banks should follow the credit rationing rule by which it fixes the rate and supply of lending at some level and don't respond to usual supply and demand mechanism.  (3) In case of collateral shortfall and inadequate cash generation, the optimum risk reduction strategy is applying the credit rationing rule. (4) Banks should either reject the loan proposal that suffers from collateral and inadequate internal cash generation or apply strict rules such as strong background check. The reason is that in most of the cases such loan proposals would be from those who are likely to be the prospective
defaulters.
Md Jamal Hossain writes from the University of Denver, USA.
 [email protected]