Moral Hazard and Credit Risk

Credit risk is a function of both quantitative and qualitative factors. While quantitative factors aim to analyze financial ratios, quantitative factors deal with soft characteristics including moral hazard which originates from information asymmetry. The scope of moral hazard does not only affect the qualitative factors but can also include the manipulation of quantitative factors. Starting from rational behavior it is less likely to assume opportunistic actions in the long run within the debt holder-equity holder conflict. Thus, the incentives of banks and other investors to minimize the potential for moral hazard should become insignificant. There are two possible scenarios in repeated interactions: Change in credit risk is due to unfaithful behavior or due to better or worse market situation. Both scenarios can also appear simultaneously and reinforce or weaken the credit risk changes. The aim of the project is to analyze the credit risk sharing and identify which (combination of) scenario(s) is more likely. It is necessary to define appropriate measures for moral hazard and empirically test its existence in the long run, i.e. repeated interactions between bank and publicly listed firms. Furthermore, collateral and covenants are considered in this context since their inclusion supposed to reflect the uncertainty about creditworthiness.