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24Feb2016yVol.16,No.06
Risks of DistorƟng Lenders’ Profit Profiles
‐ from a perspec ve of debt management ‐ Seok Ki Kim Abstract: In Korea, concerns over household and corpo‐
rate debts are rising, and yet, it is a difficult task to esti‐
mate optimal level of debts for the economy. What’s im‐
portant is that both lenders and borrowers try to maintain debts at a manageable level. To do so, lenders need to play a greater role since borrowers have an incentive to borrow more than desirable as their losses are capped. According to a study by Hart and Moore (1994), lenders consider default risks to determine optimal lending amount. Given this, it would be desirable to avoid policies that distort lenders’ profit profiles, for instance, through massive purchase of collaterals using taxpayers’ money, or by habitually bailing out strapped financial companies. When such misleading policies are implemented, market participants are likely to develop an anticipation that the government would use them again in the future. Accord‐
ingly, they would be tempted to underestimate risks of debts, resulting in greater legacy costs with more debts than desirable for the society. It is important to keep in mind that, policies that distort lenders’ profit profile have ill effects in the long run, even when they can help to sta‐
bilize the economy in the near term. Recently, in Korea, concerns over household and corpo‐
rate debts have been rising. According to BIS1), the household debts to GDP ratio reached 84% as of end‐
2014, higher than the average of advanced economies (73%) or emerging market economies (30%). The corpo‐
rate debts to GDP ratio was also quite high at 105%, compared to the average of advanced economies (81%) or emerging market economies (94%). If these loans are put to good use, money will flow to households with rel‐
atively high marginal utility, thereby increasing overall utility of the economy, and to companies with relatively high marginal productivity, to improve productivity of the economy. However, excessive borrowings spawn defaults and bankruptcy, undermine soundness of finan‐
cial companies, and might hurt overall macroeconomic conditions. Thus, it is important to keep debts at a man‐
ageable level. Since borrowings have both positive and negative ef‐
fects, it is important to set an adequate level of debts. Even if a manageable debt level can be estimated from a macroeconomic perspective, it might not be an optimal level for some households, depending on their particular circumstances. Given this, debt management policies need to be more focused on how to achieve an optimal level of debts for both lenders and borrowers, than on finding an optimal level of debts for the whole economy. However, from a standpoint of borrowers, they are likely to borrow more than an optimal amount as it is more advantages due to innate asymmetry of gain and loss2) in a loan contract. This makes it hard for borrowers to rein in their debts. Conversely, as for lenders, they lack such incentive, and thus, they are likely to play a more im‐
portant role in keeping eyes on debt management. To facilitate lenders’ efforts in figuring out an optimal level of debts by assessing risks of a loan agreement, the government policy should not distort profit profiles of lenders3). Particularly, it is important to facilitate flows of funds when loans are not paid back as scheduled. Lenders’ Profit Profile and Debt Level A study by Hart and Moore (1994)4) is widely cited when discussing debt management, which analyzed a 1) Dembiermont et. al. (2015) BIS Quarterly Review 2015 September 2) Suppose someone needs funds (10) for a project, and the interest rate is zero. Without borrowing, the profit (y) would be what remains of the project earning (x) a er subtrac ng the spent funds (y=x‐10). However, if he/she borrows 5 out of the needed funds 10, the profit would be same if the project earning is 5 or greater, and the loss would be maximum –5 if the project earning is less than 5 (y=x‐10 (x≥5) and y=‐5 (for x<5). 3) Typically, these types of policies are not desirable, and yet, government intervention might be necessary in areas of market failure. 4) Hart, Oliver and Moore, John. (1994) “A Theory of Debt Based on the Inalienable of Human Capital.” Quarterly Journal of Economics 109 6 | Weekly Financial Review
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mechanism of determining a proper debt level by the lender’s gain and loss, assuming a failure to repay debts as scheduled. In this study, authors noted that the lender’s gain or loss depends on the value of collateral, if the borrower fails to repay debts as scheduled. Suppose a borrower can generate profits greater than market returns from his/
her collaterals, by mobilizing human capital. In this case, the inside value of the collateral would be greater than its outside value for the lender who is without the same human capital. However, when the debt defaults, the lender’s gain or loss depends on the outside value of the collateral, and therefore, the optimal debt level depends on the outside value of collaterals, even though it is opti‐
mal for the optimal level of debts to be determined by their inside values, for the society as a whole. In other words, a lender’s profit profile that takes into account a probability of default eventually determines an optimal level of debts. Against this background, we can think of two scenarios whereby optimal debt level cannot be achieved due to government policies that distort lender’s profit profile. Legacy Cost First case is using public money to buy back collaterals. When the economy chills abruptly and foreclosed homes are sold off, the government might decide to use taxpay‐
ers’ money to purchase them to avoid a free fall in hous‐
ing price. However, as Hart and Moore pointed out, the outside value (auction price) of the foreclosed homes might affect the level of debt. If market participants an‐
ticipate that the government would come to their res‐
cue, financial companies would be tempted to underesti‐
mate default risks of their lending, and thus extend more loans than desirable. Second case is using taxpayers’ money to improve soundness of financial companies or for their bailouts. While the first case illustrates a scenario of indirectly affecting the lenders’ profit profile by tweaking collateral value, the second case involves a direct impact on the lenders. If financial companies anticipate that the gov‐
ernment would use taxpayers’ money to cover losses of financial companies, they would have an incentive to extend loans and increase profits accordingly, without prudent risk management. This actually happened in Ko‐
rea during the 1997 Asian financial crisis, as well as in the US at the time of the subprime mortgage crisis. What would be the consequence of government policies that distort lenders’ profit profiles? Suppose an economy is expecting a hard landing, which makes it hard for bor‐
rowers to repay debts in time and undermines lenders’ soundness. In such times, the government would be strongly tempted to employ policies that help the lend‐
ers. Pressure would sharply rise to prevent further eco‐
nomic woes. Temptation would be even greater if the epicenter of the crisis lies outside the country, as many would think that the economy would recover swiftly once the current difficulties can be overcome. Nevertheless, if the government succumbs to the pres‐
sure and implements a policy that artificially distorts the lender’s profit profile, various short‐ and long‐term con‐
sequences would ensue. First of all, wealth distribution would be distorted. Some would take away more profits than they would without such policy, and some would receive less. However, if the policy turns out effective enough to dispel a crisis, it might be worth the cost. Still, long‐term ill‐effects would be hard to avoid, most notably, legacy cost. It is a social cost incurred by repeti‐
tion of old conventions and customs. When a similar condition arises, market participants with a rational ex‐
pectation are bound to anticipate that the government would take similar actions it did last time. Specifically, if the government tried to boost the hous‐
ing market with a massive purchase of foreclosed homes, market par cipants would think that the same would happen in the next crisis. Accordingly, once the 7 | Weekly Financial Review
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24Feb2016yVol.16,No.06
crisis is over, they would borrow more to purchase more homes, and financial companies would be more generous in extending loans. A greater problem is that such moral hazard is not only applicable to those who gained from the government policy before, but to all market par cipants. Thus, there will be more and more people who want to buy homes beyond their means, and more and more financial companies that dole out loans to borrowers. In other words, a policy that is in‐
tended to rescue the housepoor might end up produc‐
ing even more housepoor. Similarly, a policy to bailout troubled financial compa‐
nies is intended to achieve macroeconomic stability, but unfortunately, it distorts borrowing behaviors and might lead to a new crisis in the future by spawning moral hazard5). These suggest that, in the long run, it is best not to im‐
plement policies that distort lenders’ profit profiles. However, short‐term effectiveness of such policies can be quite tempting, and a crevice widens between short‐
term and long‐term policy considerations. Avoiding Myopic Decisions Global financial markets are struggling with rising volatili‐
ty and uncertainties surrounding the pace of interest rate hikes in the US and the turbulent stock market in China. Under this circumstance, the Korean economy is likely to maintain the current pace of slow growth and low inflation for the time being, with a rising pressure for deleveraging household and corporate debts. A habitual bailout of financial companies at times of cri‐
ses might lead to heavy legacy costs by making crises happen repeatedly. To avoid this, policymakers should have a long‐term vision, and steadily create an environ‐
ment that encourages market participants’ voluntary debt management efforts. 8 | Weekly Financial Review
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