Adverse Selection and Access to Credit Exposure

In the finance business, especially in lending business, it is suppose that a borrower lender knows more than its lender. Let say a bank have more informational advantage regarding the borrower credit risk. In the stage of being more advantage, bank may find it more profitable to limit borrower lender’s access to bank’s credit, instead of permitting borrowers to choose the sizes of their own loans without limitation and restriction.

There is a some conduct to compensate credit risk by changing the magnitude of borrower lender’s interest rate or with rearrange schedule of borrowing rates which increase commensurate the size of the loan. This conduct is know to result in unintended consequences. In this schema, a disproportional fraction of borrower lender unforced to pay high interest rate on loan are individually aware that their poor credit quality makes high interest rate more appealing. Such a high interest rate so high that it compensates for this adverse selection could mean that almost no borrower determines a loan appealing and that the bank would do no business.

Depending upon the variance in credit risk over the population of borrowers lenders, it may be more efficient to make a limitation access to credit. Even though to some degree, adverse selection can still occur, the bank can still earn profits on average. The profit is much more depends on the distribution of default risk and the risk and private information in the population of loan borrowers.

In OTC (Over-the-Counter) derivative, such as a swamp, there is an analogous asymmetry of access to credit information involved. For example, let say, counterparty A is typically better informed about its own posses credit quality than about counterparty B’s credit quality. In this case, as well B usually knows more about its own default risk than about the default risk of A.
If we look by the same adverse selection reasoning described above for loans, counterparty A may wish to limit the degree of its exposure to default by counterparty B. Likewise, B does not wish its possible exposure to default by counterparty A to become big or large. Rather than limiting access to credit in terms of the notional size of the swap or its market value, whereas in any case is typically zero at the inception of a swap. Then it will makes sense to measure credit risk in terms of the probability distribution of the exposure to default by the other counterparty.

Over-the-counter (OTC) derivatives are contracts that are privately negotiated and traded instantly among two parties, without going through an exchange or other intermediary. OTC derivatives products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. OTC derivative market is the largest market for derivatives, and is unregulated. According to the Bank for International Settlements, the total outstanding notional amount is $596 trillion. Of this total notional amount, 65% are interest rate contracts, 11% are credit default swaps (CDS), 8% are foreign exchange contracts, 3% are commodity contracts, 2% is equity contracts, and 11% are other. OTC derivatives are largely subject to counterparty risk, as the validness of a contract depends upon the counterparty’s financial condition and ability to abide by its obligations.

Based on adverse selection describe above, there is analogous relationship between quantitative exposure limits to a stock specialist’s limit on size for market orders. Adjusting a lower limit reduces volume and thereby make profits limited. Adjusting a larger limit encourages the selection of positions with adverse credit quality. A trades between those two effects is an “optimal” limit we can do.

We expect that limits should be based on any information available on credit quality. For example, Aaa-rated counterparties should have higher limits than Baa-rated counterparties, for there is a relatively small likelihood that a large position initiated by an Aaa-rated counterparty is designed to exploit the broker-dealer’s incomplete information of the counterparty’s access to credit quality.