The Research on Correlations of Credit Risk and Moral Hazard for the EG

Abstract

This paper， under the assumption of risk-neutral， analyzed the relationship between the probability of occurrence of moral hazard and the default probability of the EG（enterprise group）， theoretically demonstrated the inner mechanism between the moral hazard and credit risk of the EG， and highlighted the role of bank loan interest played in the control of moral hazard and credit risk. The research shows： （1） There is nonlinear relationship between the probability of occurrence of moral hazard and the default probability of the EG； （2） There is an exogenous variable， loan interest rate， which makes the default probability extremum.

Key words： EG （Enterprise Group）； Moral Hazard； Default Probability； Loan Interest

INTRODUCTION

The EG （Enterprise group） is a combination of enterprises， with the large enterprise as the core， based on the equity relationships， economic and technical， or contact management. The moral hazard in this paper means the business risk that the EG make use of the low-risk project to apply for loans to banks and transfer the loans to the high-risk project to take high profits.

The EG usually has complicated inner structures and many affiliated companies that are either in different stages of their development or under different industry environment， so the levels of benefits and risks of their proposed investment projects are with great differences as well. Countless cases show that the direct reason for operating or financial crisis of the EG is that they used loans for other purposes without following the loan agreements. The commercial banks are usually at a disadvantage of asymmetric information when the loan is transferred within the EG. In this situation， the flow of loan is very difficult to be supervised. Thus， there is the driven force for the occurrence of moral hazard. As the moral hazard can lead to risk business of the EG， thus increase their credit risk. The changes in credit risk in turn would affect the decision-making behavior of the EG， which would also lead to further change in the likelihood of occurrence of moral hazard. Thus， it is with great academic value and practical significance that we reveal the intrinsic link and mechanism of interaction between the moral hazard and credit risk of the EG.

By far， researches on credit risk are primarily around the measurement and prediction of default probability， such as the classic structure model by Merton [1]， the simplified model under the assumption that the default events are random[2]， and various kinds of econometric models based on statistics or artificial intelligence[3]. There are some papers about quantification of credit risk of the EG. For example， Chen studied infection mechanism of credit risk in the EG [4，5]， and he also discussed moral hazard problem of the EG in the principal-agent framework[6]. However， there are rare literatures on the interaction between the moral hazard and credit risk of the EG.

We discussed the relationship and interaction between the probability of occurrence of moral hazard and the default probability of the EG， and depicted the underlying mechanism between the moral hazard and credit risk at the theoretical level. The rest of this paper is organized as follows. Section 2 of this paper is some relative assumptions； the influence of interest rate on moral hazard and credit risk of the EG was analyzed respectively in section 3. On this basis， the transfer of moral hazard to credit risk and reaction of credit risk on moral hazard of the EG were discussed.

1. RESEARCH BACKGROUND & ASSUMPTIONS As we mentioned， the moral hazard in this paper means that the EG use loans for other purposes without following the loan agreements. To simplify our discussion， we make an assumption that one EG is composed of two companies， Company A and Company B. A has a highrisk， high-yield investment project， Project A， which does not have a direct qualification to apply for loans to banks， whereas Company B has low-risk project， Project B， which can get the loans from banks. Generally， we made the following hypotheses.

Assumption 1： For the high-risk Project A， the investment capital is x. The success probability of it is PA， and it will get a positive earning xθA1， while the failure probability of it is 1-PA and it will get no earning at all. The distribution function of θA is Φ（.） and the density function is φ（.）

Assumption 2： The low-risk Project B has the characteristics of all general projects， of which the return yield can be described by using the model of meanshifting investment technologies （Koskela， 2000） [7] . In other words， assume that the return yield of the Project B is continuous. For investment capital x， the return of the Project B， t， is the random return in [0， xθB ]， and its conditional distribution function is F（τ│x） while conditional density function is f（τ│x）. For the Project B， xqB is upper bound of investment capital x. If the revenue of the Project B is not enough to pay back loan principal and interest to the bank， it will be considered as a failure of the Project B.

Assumption 3： Once there is a failure of any projects， the whole EG defaults.

Considering the reality， we also made other hypotheses as follows.

Assumption 4： The game between bank and EG is dominant， in other words， the bank does not know anything about the high-risk information of the Project A.

Assumption 5： If the interest rate is high enough， the probability of default of the EG will increase with the rise of interest rate.

Inference 2： As the probability of occurrence of moral hazard is monotonic increasing， the default probability get maximum at first， then get minimum.

Furthermore， according to formula （6） to （8）， the smaller difference between AAPθ and Bθ is， the lager H（r）is， and the smaller the probability of the occurrence of moral hazard is. Now we can depict the transfer mechanism from the moral hazard of the EG to the credit risk， which is：

（1） If the probability of the occurrence of moral hazard is zero， the default probability of the EG， is equal to the probability with which the Project B failed.

（2） If the expected return of the Project A is only a little larger than the upper bound of that of the Project B， the probability of the occurrence of moral hazard is relatively small. Once the moral hazard occurs， the default probability of the EG will show a monotonic increasing trend as the rise of interest rate. （Shown in left part of Figure 1）

（3） If the expected return of the Project A is far more than the upper bound of that of the Project B， the probability of the occurrence of moral hazard is relatively large. In this situation， as the increase of interest rate， the default probability of the EG will show a trend that goes down at first and then increase.

In other words， the decrease of interest rate can reduce the moral hazard but cannot make the default probability of the EG minimum， and banks will not be satisfied with a very low interest rate， either. Thus， banks tend to find a best interest rate. From formula （12）， the interest rate that makes default probability of the EG achieve extreme value depends on the value of PA， which is the private information of the EG. So it is difficult for the banks to detect the change of credit risk when the moral hazard occurs in the EG. This is one root that why current the EG often occur credit crisis， which brings the banks huge loss.

CONCLUSION We’ve discussed inner mechanism between the moral hazard and credit risk of the EG， and got some significant theoretical conclusions as follows. （1） There is nonlinear relationship between the probability of occurrence of moral hazard and the default probability of the EG； （2） There is an exogenous variable， loan interest rate， which makes the default probability extremum.

The study also shows that banks could use a low interest rate strategy to reduce the probability of moral hazard of the EG， which is monotonic decreasing with the decrease of banks’ interest rate. On the other side， banks will face a dilemma when determining the interest rate， because the credit risk of the EG is actually not monotonic decreasing with the decrease of interest rate.

As the difficulty of data collection， we have described

the interaction mechanism between moral hazard and credit risk of the EG only from the theoretical level. What’s more， we have made some necessary simplifications and assumptions for the convenient of our discussion， so it is to collect real data to simulate the return distribution and spread these conclusions to more general cases that is our research work in the coming step.

REFERENCES

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