APRIL 2011

A Theory of Monitoring Credit Risk

Douglas Dwyer
1

Moodys Analytics
April 2011

Abstract
On any given day, credit analysts monitor multiple names. Some names will have been reviewed recently,
but not all. Some names are easily traded out of, while some names are more difficult to hedge. Some
names represent large exposures while others represent small. Some are known high credit risks while
others are low credit risks. The risk profile of some exposures may have changed recently while others
remained unchanged. How to triage? Which names should the analyst review first? Next? Ultimately, how
does the institution value a credit review? This paper derives an optimal monitoring strategy, under the
assumption that there is a fixed cost for reviewing a loan. The framework can be embedded within a
dynamic competitive equilibrium in which prices reflect public information. We calibrate the framework
using parameter values with empirical interpretations. In the dynamic setting, we show that in specific
circumstances, a mid-year review can produce incremental value equal to 1.3% of the exposure size.


1
douglas.dwyer@moodys com. We would like to thank Ivo Antonov, Heather Russell, Roger Stein, and Jing Zhang
for valuable feedback on this paper. We also appreciate feedback from the Moodys Academic Advisory Board and
participants at the Moodys Analytics Risk Practitioner Conference. Andrew Caplin, Boyan Jovanovic, and John
Leahy provided valuable direction.



1 Introduction
Monitoring credit risk is costly, and one cost is the collection and analysis of information. In the past
decade, financial institutions have invested in systems that provide credit managers access to regularly
updated credit risk information. With such information systems in place, credit managers can access
timely information at a marginal cost of close to zero. Depending on the asset class, available information
may include credit spreads, financial statements, and the borrowers conduct on the account. Information
may also include quantitative models designed to assess the borrowers credit risk. Models can include a
probability of default based on a structural model for larger firms with listed equity. For medium-sized,
private firms, a financial statement-based probability of default (PD) derived from a quantitative model
may be available. For small firms and consumer credit, measures of credit risk based on behavioral
information may be available (e.g., a credit score).
Informations value lies in its potential to change action, and credit managers make decisions and act
based upon updated information. Actions may include originating new loans, extending additional credit to
existing borrowers, not refinancing a maturing term loan, cutting lines of credit, buying insurance against
a borrower defaulting, selling the exposure to another financial institution, working with the borrower to
establish an alternative source of financing, and finally, securitizing the exposure off the balance sheet via
a collateralized loan obligation. In consumer credit, managers make loan decisions using only quantitative
risk metrics (i.e., a credit score). In contrast, financial institutions use a combination of quantitative risk
metrics and a review of qualitative information to assess large exposures. Performing additional analyses
requires resources that have a direct cost.
2

Risk management departments review credits periodically according to specific requirements set by
regulators and financial institutions. The OCC prescribes reviewing high risk credits more often and allows
for smaller, performing credits to be reviewed less often (page 9, Rating Credit Risk, OCC, 2001).
Depending on resources, credit analysts may conduct an annual review of each credit, and they may
conduct an additional review whenever the quantitative measure of risk differs from the internal rating by
a significant margin. A major change in the borrowers business or balance sheet may trigger a review.
The reviews outcome may be a new internal rating or a new PD; the new rating may require the bank to
take an action on the loan.
In this paper, we focus on measuring the economic value of a review and deriving an optimal review
policy within a theoretical setting. In the core framework, prior to the review, the credit analyst has a
partial information PD with which to assess the risk-return trade-off of the exposure. If the credit analyst
chooses to conduct the review, the credit analyst has a full information PD with better discriminatory
power. The outcome of the review is both a new and more informative PD, as well as a decision
regarding whether or not to take action on the exposure; the lenders action is to sell the exposure. If the
lender sells the exposure, he loses the spread income while preserving the principal.
3

Ex post, the review adds value when it leads a manager to a different action to either hold a name they
would otherwise sell or to sell a name they would otherwise hold. The ex ante value of the review per unit
of exposure is the difference in the expected return on the loan under full information with optimal selling
versus partial information with optimal selling, given partial information. The value of the review is largest
on the names that the portfolio manager is indifferent between holding and selling under partial
information.


2
Dwyer and Russell (2010) present one approach to combining qualitative factors with a quantitative risk metric.
3
When an institution decides to limit their exposure to a particular borrower, they have multiple actions they can take
(enforcing covenants, cutting lines of credits, buying default insurance, securitization, and so forth). The available
actions depend upon the specifics of the relationship as well as the asset class. The most straightforward of these
actions to model is the simple selling of the loan (or not extending credit in the first place), which is why we begin by
modeling this scenario.



We extend the framework to include a time dimension; the information content of a review erodes over
time since the last review. We derive an optimal review policy in which some relationships are reviewed
regularly and others periodically. We also show how the framework can be embedded in a competitive
general equilibrium. In this setting, the spread charged to the borrower is agreed upon prior to the review
being conducted. The spread must be large enough to cover both a transaction cost associated with
managing the relationship as well as the credit risk associated with the loan. In this equilibrium, the
spread on the loan reflects public information, but not private information. Based on public information,
the riskier loans require higher spreads. Conditional on public information, the safest loans are reviewed
less often than the riskier loans. For a given level of public information, there is a U-Shaped relationship
between the frequency of review and the level of credit risk implied by the private information.
We contrast the value of the relationship under an optimal review policy with the value of the relationship
under a fixed review cycle of every year. The incremental value of the review is greatest when the optimal
review policy is to review the loan more than once each year. This multi-annual review occurs for loans
with elevated risk according to public information and a more favorable level of risk under full information.
We find that, in some circumstances, the incremental value of a mid-year review can exceed 1% of the
exposure amount.
The building blocks of the framework include probabilities of default, average default rates for a
population, and cumulative accuracy profiles (CAP). Financial institutions now collect such information as
part of the Basel II initiative. Therefore, the framework can potentially be calibrated to an asset classes
specific settings. The base case we use throughout the paper is calibrated to be consistent with three
empirical benchmarks: (i) a partial information CAP curve comparable to that which can be achieved
through a commercially available, financial statement-based probability of default model; (ii) the amount
of information available utilizing both public and private information is comparable to that which can be
achieved using a structural model of default that incorporates equity prices and is commercially available;
and (iii) the average default rate of the population is 2% per annum. These benchmarks are reasonable
starting points for analyzing the optimal review policy for debt issued by private firms large enough to
have listed equity, but do not have listed equity. Different asset classes would likely require different
calibrations.
Relation to the Literature
This paper draws upon two different bodies of literature: power curves and the economics of inaction.
Researchers use power curves to quantify the predictive power of a medical test or a credit risk model.
We draw from the economics of inaction literature to derive the optimal dynamic policy for reviewing a
credit.

In medical testing, the outcome of a test can be a continuous variable, for which higher levels are
associated with higher incidences of a disease (e.g., higher blood pressure is associated with a higher
likelihood of heart disease). One may want to determine a threshold for the test outcome. If the test
outcome is above this threshold, the disease is treated (e.g., medication is given to prevent heart
disease) and not otherwise. In determining this threshold, one considers the rates of true positives
(treating someone who does have the disease), false positives, true negatives, and false negatives
implied by the threshold, as well as their associated costs and benefits, and then optimizes accordingly.
Power curves are analytic tools used in the biostatistics literature for this purpose.
4
Roger Stein (2005)
drew upon this literature to determine optimal lending policies in the context of managing credit risk. He
also showed how to compute the benefit to a financial institution of using one model relative to another in
a variety of settings. This paper uses the same tools, but takes a step back. It views the test as having a
cost to administer, and it considers whether or not the value of knowing the outcome of this test justifies
the cost of administering the test.
5



4
Power curves include Receiver Operator Characteristic curves (ROC curves) and Cumulative Accuracy Profiles
(CAP curves).
5
Biostatisticians study this question as well. Mandelbatt et al. (2009) provide a recent and controversial example.



Economists have developed theories in which it is optimal for agents to do nothing for periods of time in a
dynamic setting (c.f., Stokey, 2009). When an action has a fixed cost, one can typically derive an optimal
range of inaction. Economists have used such theories to explain stickiness in prices and wages,
investment spikes, and the slow adoption of new technologies. In this line of research, one paper
explicitly models the fixed cost as the cost of acquiring and analyzing updated information (Reis, 2006).
Reis models the fixed cost of changing a price as the cost of updating one's information, and the new
information is used to reset the price to an optimal level. He focuses on explaining the dynamics of
inflation. While the contexts are different, the structures of the dynamic programming problems are
similar: we both model the optimal wait time to update ones information in an infinite horizon setting.
The remainder of the paper is organized in the following way.
Section 2 presents the basic framework of the model, in which there is both a partial information PD
and a full information PD. We show how to derive the CAP plots as well as the value of information in
a static setting.
Section 3 incorporates a time dimension and shows how to solve for the optimal review policy in a
dynamic setting.
Section 4 argues that the framework can be embedded into a dynamic competitive general
equilibrium, in which prices reflect public information.
Section 5 calibrates the framework to actual examples and characterizes the equilibrium spreads as
well as the optimal review policy.
Section 6 looks at the question: how much value does pursuing an optimal review strategy create?
Section 7 provides concluding remarks.
Appendix A is a table of the symbols used in the paper.
Appendix B derives the distribution of PDs and the Cumulative Accuracy Profiles implied by this
framework.
Appendix C describes the algorithm used to calibrate the model parameters for the benchmark case.





2 The Model
We model how to determine the value of information for specific names in a portfolio. We presume the
resources required to execute a review are costly, and the outcome of the review may be a decision to
hedge the exposure for a specific cost. The credit analyst should choose to hedge the exposure if the
credit risk is very elevated relative to the sum of the spread and the transaction cost of selling the loan.
The credit analyst can make this decision using either partial information or full information. The marginal
cost of the partial information is assumed to be zero, whereas, obtaining full information on a specific
credit has a cost. We compute the value of information per unit of exposure as the difference between the
expected return under full information, where the credit analyst acts optimally, and the return based on
partial information, where that the credit analyst acts optimally using the available information. In this
setting, information is valuable when it leads an analyst to act differently.
2.1 The Basic Framework
Suppose you have an exposure with a full information PD defined by:
0
( ) N +X
In this equation, X is a row vector, the elements of the row vector are standard normal variables
independent of each other, is a column vector of coefficients, and
0
is a scalar, i.e., the intercept. The
function, N, is the standard cumulative normal distribution. Without loss of generality, we assume that all
the elements of are positive so that large values of X correspond to elevated credit risk. We will assume
that the intercept,
0
, is negative, which implies that the median credit has a probability of default of less
than 50%. We can give a latent variable interpretation to the full information PD as follows. Let be a
latent variable that has a standard normal distribution. Default occurs if:
0
< +X
The probability of being less than
0
+X is given by
0
( ) N +X , i.e., default occurs when there is
a sufficiently bad realization of the latent variable . Partition Xinto Y Z so that Y Z = + X , where
Y is known and Z is unknown. Using this notation, we define the full information probability of default as:
0 0
( , ; , , ) ( )
FI
PD Y Z N Y Z = + + (1)
Now we derive the partial information PD. Default occurs when:

0
Y Z < + +
or
0
1 1
Y Z

+
<
+ +


Note that the left-hand side of this last equation has a standard normal distribution. Therefore, the partial
information PD is given by:
0
0
( ; , , )
1
PI
Y
PD Y N



+ | |
=
|
+
\
(2)


By the same argument, if both Y and Z are unknown, then the PD is given by
0
1
N

| |
|
|
+
\
. For
convenience, we refer to this quantity as the CDT, the Central Default Tendency. The CDT is the average
default rate of the population.
It will be convenient to define ( ) ( )
1/ 2 1/ 2
0 0

1 ; 1

= + = + so the partial information PD can
be written as
0

( ) N Y + .

2.2 Distribution of PDs and Cumulative Accuracy Profiles
In Appendix B, we construct the distribution of the partial information PDs and the full information PDs.
We also derive an expression for the Cumulative Accuracy Profile (CAP curves) and the corresponding
Accuracy Ratio (AR). These constructs allow us to calibrate the parameters using empirical reference
points. We show that the quantile functions of the full information and partial information PDs are given
by:
( )
1
0
( ) ( ) '
FI
F q N N q

= +
and

( )
1
0

( ) ( ) '
PI
F q N N q

= +

These functions take a percentile as an input and produce the PD associated with that percentile. For
example, if q=0.975, then 97.5% of the population has a full information PD of less than F
FI
(0.975). The
CAP curve for the full information and partial information PDs are given by:
( )
1
0
0
( ) ( ) '
x
FI
CAP x N N q dq CDT

= +

and
( )
1
0
0

( ) ( ) '

= +

x
PI
CAP x N N q dq CDT


Figure 1 presents the quantile function for full information and partial information PDs based on a CDT of
2% and of 0.9 and of 0.5. The figure compares the distribution of the full information PD with that of
the partial information PD. We find that the distribution of the full information PD is more dispersed than
the distribution of partial information PDs. Figure 1s right hand panel focuses on upper percentiles of the
distribution. Under this parameterization, the AR of the partial information PD is 77.8%, and for the full
information PD, the AR is 85.5%. An AR of 85.5% is roughly comparable with the accuracy ratio of the
Moodys KMV public firm model on a large sample at a one-year horizon and exceeds the accuracy ratios
typically found in private firm models. An AR of 77.8% is roughly comparable to the AR that can be
achieved using a financial statement-based model on a comparable sample. A population default rate of
2% is a reasonable value for the long-run average default rate for a Commercial and Industrial portfolio.
6

Note that the partial information PD is larger than the full information PD for 91% of the sample, but for
the riskiest names, the full information PD is larger than the partial information PD. Also note that the
median partial information PD (about 0.40%) is three times larger than the median full information PD
(about 0.13%).



6
See Sections 2.4 and 4.8 of Dwyer and Zhao (2009).





Figure 1 Quantile Function for Full and Partial Information PD
2.3 Determining the Value of Information
Consider an exposure that pays back the principal plus a coupon in one time period (e.g., one-year) from
now. We will refer to the principal as the exposure or size of the loan. The coupon is equal to s + r per unit
exposure, where r is the risk free rate and s is the spread over the risk free rate. The transaction cost
associated with selling the loan is h. For convenience, we assume that the coupon is paid whether or not
default occurs, and, if default occurs, the LGD is 100% of the principal. We assume that the risk manager
is risk-neutral, and that the risk manager currently holds the exposure. The risk manager hedges if the
probability of default exceeds the spread, plus the transaction cost. Under full information, the risk
manager hedges if the risk of holding the exposure (the full information PD) exceeds the return on holding
the exposure, plus the transaction cost (s+h):
( )
0
N Y Z s h + + > +
If the complete information PD is not available, the risk manager hedges if:
( ) 0

N Y s h + > + .
Before deriving the value of information, in general, going through a specific example is instructive.
Suppose that the transaction cost is 0%, the spread earned on the loan equals 2%, and the partial
information PD is 2.01%. If full information is not available, then the risk manager hedges, in which case
he loses 0% versus an expected loss of 0.01% associated when holding the position.
Let the vectors Y and Z each have one element, and let =0.9 and =0.5. We can solve for
0
so that the
default rate of the population is 2%:
0 25 50 75 100
0.01
0.10
1.00
10.00
100.00
Percent of Population
P
D

(
%
)


Full
Partial
80 85 90 95 100
1.00
10.00
100.00
Percent of Population
P
D

(
%
)


Full
Partial



1 2 2
0 1 1
0
0
2
1
1
1
2
1
(.02) 1 2.948

2.636
1
0.805
1
N

= + + =
= =
+
= =
+
.
The partial information PD is given by:
( 2.636 0.805 ) N Y +
One can verify that if Y equals 0.726, the partial information PD is 2.01%. As Y has a standard normal
distribution, this implies that 76.6% (N(0.726)) of the population has a partial information PD of less than
or equal to 2.01%. Suppose that the risk manager conducts a loan review and obtains Z, and that the
realized value of Z turns out to be 0. Then the full information PD is given by N(-2.948+0.9*0.726+0.5*0)
or 1.090%. Therefore, a neutral realization for Z lowers the PD of the exposure and leads a risk manager
not to hedge the exposure. In this case, the expected return on the exposure is now 0.91%. The
additional information saves the risk manager 0.91% (the expected return on the loan). For this example,
whether or not the fully-informed risk manager chooses to hedge the loan depends on the realization of Z.
The fully-informed risk manager hedges if the full information PD exceeds 2%:
( 2.948 0.9 0.726 0.5 ) 2% N Z + + >
Taking the normal inverse of both sides and solving for Z reveals that the fully informed risk manager
hedges whenever Z is greater than 0.480, approximately 31.6% of the time. In this example, full
information leads the risk manager to do what he would have done under partial information about 31.6%
of the time and to do something different 68.4% of the time, i.e., he chooses not to hedge the loan. If he
chooses to conduct a credit review, the value of the credit review equals the probability that he acts
differently as a result of the review (he does not hedge the loan), N(0.480), multiplied by the expected
gain from not hedging the loan, given that he does not hedge the loan. The value of information is given
by:

0.480
( 2.948 0.9 0.726 0.5 ) ( )
(0.480) 0.02
(0.480)
N Z n Z dZ
N
N

| |
+ +
|

|
|
\

where n is the density function of a standard normal distribution. Using numerical techniques to evaluate
the integral, we find that the value of information is 0.860% for this example. Therefore, the risk manager
would pay up to 0.860% of the amount of the exposure for knowledge of Z. Figure 2 depicts this example
plotting the full information PD and the excess spread, h+s-PD
FI
, as a function of Z. Note that it is a
skewed distribution, in that the downside associated with large realizations of Z is larger than the upside
associated with positive realizations of Z. Under partial information, the value of the loan is close to zero.
Under full information, the value of the loan equals the probability of the excess spread being positive
multiplied by the expectation of the distribution of the excess spread truncated to the positive region.




Figure 2 Full Information PD and Excess Spread, as a function of Z

The general solution to this example for the case that the partial information PD leads the risk manager to
hedge (partial information PD> h + s) is:
( )
0
( ) ( )
( )
( )
cv
N Y Z n Z dZ
N cv h s
N cv

| |
+ +
|
+
|
|
\

where
( )
1
0
( ) N h s Y
cv

+ +
= .
Here cv is the realized value of Z that leads the risk manger to be indifferent between hedging and not
hedging. N(cv) is the probability that the risk manager does not hedge (i.e., the probability of doing
something different), h + s is the spread on the loan plus the transaction cost and
0
( ) ( )
( )
cv
N Y Z n Z dZ
N cv

+ +

is the expected loss on the loan, conditional on a good outcome for the
review (i.e., Z<cv).
For the case in which the partial information PD leads the risk manager not to hedge (partial information
PD< h + s) the value of information is
( )
0
( ) ( )
1 ( )
1 ( )
cv
N Y Z n Z dZ
N cv s h
N cv

| |
+ +
|

|

|
\

.

In this expression, each term has an analogous interpretation as in the prior expression. (1-N(cv)) is the
probability that the risk manager hedges (i.e., the probability of doing something different),
0
( ) ( )
1 ( )
cv
N Y Z n Z dZ
N cv

+ +

is the expected loss on the loan conditional on a bad outcome for the
review (i.e., Z > cv), this loss is saved as the loan is hedged, and the spread and the transaction cost are
subtracted as this money is lost by hedging.
-20%
-10%
0%
10%
20%
30%
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2
Realized Z
F
u
l
l

I
n
f
o
r
m
a
t
i
o
n

P
D
/
E
x
c
e
s
s

S
p
r
e
a
d
Full Information PD Excess Spread



In the general case, the value of information can be expressed as:
( )
( )
0
0
0
( ) ( )
( , , ; , , ) ( )
( )
( ) ( )
(1 ( ))
( )
cv
PI
cv
PI
N Y Z n Z dZ
VI Y h s PD h s N cv h s
N cv
N Y Z n Z dZ
PD h s N cv h s
N cv

+ +
= > + +
+ +
+ < +
| |
|
|
\
| |
|
|
\

(3)
where cv and PD
PI
are defined as above, and (x) takes on a value of 1, if the statement x is true and 0
otherwise. The value of information is expressed as a proportion of the exposure.

Table 1 Value of the Review (bps)
Partial Partial Partial Partial Information PD Information PD Information PD Information PD
0.10% 0.10% 0.10% 0.10% 0.20% 0.20% 0.20% 0.20% 0.50% 0.50% 0.50% 0.50% 1.00% 1.00% 1.00% 1.00% 2.00% 2.00% 2.00% 2.00% 5.00% 5.00% 5.00% 5.00% 10.00% 10.00% 10.00% 10.00% 20.00% 20.00% 20.00% 20.00% 50.00% 50.00% 50.00% 50.00%
h
+
s
h
+
s
h
+
s
h
+
s

(
b
p
s
)
(
b
p
s
)
(
b
p
s
)
(
b
p
s
)

10 10 10 10 6 4 2 1 0 0 0 0 0
20 20 20 20 4 11 6 3 1 0 0 0 0
50 50 50 50 2 6 25 16 7 1 0 0 0
100 100 100 100 1 3 16 47 27 7 1 0 0
200 200 200 200 0 1 7 27 86 33 8 1 0
500 500 500 500 0 0 1 7 33 186 75 14 0
1000 1000 1000 1000 0 0 0 1 8 75 320 94 1
2000 2000 2000 2000 0 0 0 0 1 14 94 515 22
5000 5000 5000 5000 0 0 0 0 0 0 1 22 738

Table 1 presents the value of information as a function of (h+s) and the partial information PD for a CDT
of 2% and of 0.9 and of 0.5. Note that holding the partial information PD constant (moving down a
column), the value of information is greatest where the firm is indifferent between holding/hedging the
exposure under partial information. Further, note that the maximum value of information for each partial
information PD increases with the PD. The value of information has the potential to be the largest for the
loans with the largest expected losses. The value of information is fairly sizable. For example, suppose a
financial institution has a $10mm exposure to a firm with a partial information PD of 2% and a spread of
100bps. Under this framework, the financial institution should review the loan provided the cost of the
review is less than $27,000.
Such a table could be used to determine the exposures to review first to triage. Nevertheless, up to this
point, the framework abstracts away from the fact that credit analysts manage a portfolio over time. We
now turn to incorporating a time dimension into the framework.




3 Incorporating a Time Dimension
Banks manage credit risk through time. Whether or not a bank reviews a loan today depends upon the
last time the bank reviewed the loan. The value of the information collected during the review process
decays over time. In this section, we show how to incorporate a time dimension into the problem by
assuming that both the terms of the loan and the public information are fixed over time, but the private
information varies over time. We also provide a general setup of the problem using transition matrices. In
subsequent sections, we show how the framework can be embedded in a general equilibrium. We
characterize the solution to the framework and the implications for equilibrium prices using three different
examples.
The Dynamic Programming Problem
Suppose a bank has an option to lend to a specific borrower at a fixed spread until the lender defaults.
The public information for the borrower is time-invariant, while the private information, S
t
, changes over
time.
The timing of events within the period is as follows. Going into the period, there exists a value of S
t
. By the
end of the period, a new value of S
t+1
is realized. At the start of the period, the lender first chooses
whether or not to review the loan, and then chooses whether or not to sell or buy back the loan.
7
Then,
the default event is or is not realized, and the probability of default in period t is determined by S
t
. The
principal is then refinanced/repaid if default has not occurred, and the principal and the coupon is lost in
its entirety if default does occur. Finally, the new value of S
t+1
is realized at the end of the period. If the
lender chooses to review the loan in period t, they know the exact value of S
t
, and carry this knowledge
into the next period. Payments made j periods from now are discounted at
j
.

Let there be N possible states, and let the i-th element of the vector S imply the value of S for state i with S
increasing in i. Let state N be the absorbing state that implies default. And let D
t
be an N element row
vector denoting the distribution of the borrower across these states based on the information available to
the lender at the start of the period (prior to doing the review). Let D(i) be a vector such that the ith
element equals one and 0 otherwise. This vector represents the distribution of the borrower across
possible states when the borrower is known to be in state i. Let be the transition matrix governing the
probability of moving from state i to state j in the next period. As the last state is the absorbing state, the
last column of this matrix is the probability of default from each state. For convenience, let PD denote the
last column of . . . .
Let CoR be the cost of a review, which is constant over time.
Given the initial distribution, the distribution across the states in period j is given by:
j
t j t +
= D D
Let R
k
be a column vector representing a given review strategy. The i-th element of this vector is the
number of periods one waits to review an exposure that starts out in state i. Let V
k
be the value of having
a relationship with a borrower that is known to be in state i given review strategy R
k
. Define the i-th
element of the vector R
k+1
as:
( )
1
1
0
( ) arg max max( (1 ) ( ) , 0) ( ) CoR
r
j j r r
k r k
j
R i s s i i

+
=
| |
= + +
|
\

D PD D V -

(4)


7
By assuming that the lender can freely sell/buy back the loan, the only dynamic decision is whether or not to review
the loan. This assumption makes the problem more straightforward to solve, as whether or not the borrower sells or
buys back the loan during the current period does not impact cash flows in the next period.



Define the i-th element of the vector V
k+1
as:
( )
1
1
0
( ) sup max( (1 ) ( ) , 0) ( ) COR

+
=
| |
= + +
|
\

r
j j r r
k r k
j
V i s s i i D PD D V -
(5)
In both equations, the term
1
0
max( (1 ) ( ) , 0)
r
j j
j
s s i

=
+

D PD represents the present discounted value

of expected cash flows earned until the next review is conducted. If one chooses to lend in a given period,
the expected cash flows are (1 ) ( )
j
s s i + D PD. The max(X,0) operator captures that one would not
lend if this quantity is negative. In both equations, the term ( )
( ) COR
r r
k
i D V - reflects the value of
the loan after conducting the review in r periods.
If R
k+1
= R
k
then the strategy is optimal, and the vector V
k+1
is the value of having a relationship with this
borrower for each possible initial state.
8
One numerical approach to solve this value function is the
following. First, compute the value function using an R
0
, in which every element is infinity (i.e., never doing
a review). This value function involves computing an infinite sum that can easily approximate by
evaluating the first 500 terms. Using this value for V
0
, one can compute R
1
directly. For each initial state,
compute the value of the relationship if it was reviewed in periods (1, 2, 3.) and find the maximum. This
process determines both R
1
and V
1
. One then iterates until convergence to determine the optimal strategy
and the corresponding value function.
Note that the value of the relationship is bounded below by zero and above by the present discounted
value of s being paid for certain, every period, in perpetuity. Also, note that the value function does not
explicitly include cash flows associated with investing the principal in another instrument (e.g., a risk free
security), should the lender choose to not extend credit. Consequently, s should be interpreted as the
spread in excess of the risk free rate.



8
This result is an application of Theorem 9.2 of Stokey and Lucas (1989).



4 A Competitive Dynamic General Equilibrium
Up to this point, the framework shows how the lender can make an optimal decision, taking both the
probability of default by a borrower and the spread on a loan as given. In a competitive general
equilibrium setting with full information, there is a close linkage between the probability of default and the
spread on the loan. In this section, we show how to embed the framework within a competitive dynamic
general equilibrium, in which prices (i.e., spreads) reflect public information but not private information.
This section shows that such equilibrium is possible using a very minimal model.
In this setting, a borrower (who we term the entrepreneur) and a lender (who we term the venture
capitalist) agree to terms before the lender reviews the loan so that the coupon paid on the loan does not
depend on the full information probability of default. We assume the entrepreneur and the venture
capitalist possess symmetric information, in that, both can access the reviews outcome after it is
conducted.
At the start of each period, there is a new cohort of entrepreneurs. Each entrepreneur of type i can either
produce one unit of consumption good for certain or an uncertain amount of consumption goods with a
fixed and known distribution (provided they do not default). A venture capitalist provides an office to the
entrepreneur. The entrepreneur requires an office, which he cannot produce himself. An office costs x
units of consumption to produce, and the office of one entrepreneur cannot be reassigned to another
entrepreneur. Further, the office provides no direct utility to the entrepreneur or the venture capitalist. The
venture capitalist can choose to offer the entrepreneur a retainer of one unit of consumption prior to
conducting the review. If successful, the entrepreneur refinances the principal with the venture capitalist
and pays the coupon. The venture capitalist will choose not to refinance the loan if the odds of failure
exceed the coupon on the loan. This decision is reversible; the venture capitalist can hire back the
entrepreneur during the next period if he chooses to do so. Once the entrepreneur defaults, they either
leave the economy or produce one unit of consumption good for certain.
We set up this equilibrium so that the interpretation of the coupon is, in a sense, comparable to a spread
in excess of the risk free rate. We assume that all consumption occurs at the end of the period. By
making this assumption, the lender is made whole on the use of the retainer when the borrower repays
the principal at the end of the period. The coupon is only used to pay for the office, the cost of the review,
and the credit risk. After being assigned, the opportunity cost of the entrepreneur using the office is zero
it is a sunk cost.
The spread on the loan is contracted based on public information. The venture capitalist can choose to do
a review and then hedge the relationship. Alternatively, the venture capitalist can choose not to conduct
the review and then choose whether or not to hedge the relationship. The review costs CoR units of
consumption goods. Further, the outcome of the review is known only by the entrepreneur and the
venture capitalist other venture capitalists do not have access to the outcome. If the venture capitalist
chooses to hedge the relationship in that period at the contracted spread, the entrepreneur can make a
counter offer that the venture capitalist must accept or reject. If the relationship is hedged during the
current period, the entrepreneur utilizes the risk free technology to produce one unit of consumption
goods.
There is a mass of possible entrepreneurs and an arbitrary number of venture capitalists. The quality of
an entrepreneur is measured by the full information probability of default and the distribution of the output
that he could produce. In each period, there is a new cohort of possible entrepreneurs. The distribution of
the quality of each new cohort of entrepreneurs in each period is constant over time. The probability of
default by any entrepreneur is bounded below by a positive number.
Let the representative agents utility be given by:
1
( )

t
t
t
u c



where u is defined for positive c and exhibits diminishing marginal utility. Specifically, u is continuous, with
continuous first and second derivatives. Further, the first derivative is positive for all positive c, and the
second derivative is negative for all positive c.

Proposition

There exists a competitive equilibrium in which:

1. All agents act in an optimal fashion, given the actions of others.
2. Output produced is constant over time.
3. The coupon charged to the entrepreneur sets the value of the relationship for the venture
capitalist, equal to the cost of producing an office in foregone consumption goods.
4. A constant proportion of output is consumed and a constant proportion of output is used to
produce offices for new entrepreneurs, and the remainder is used to pay for the credit reviews.
5. The expected value of a relationship with a new entrepreneur is equal to x consumption units.
6. The coupon charged to the entrepreneur is either the contractually agreed upon spread or
renegotiated to the odds of default.
7. The relative prices across time are determined by the discount factor, i.e., p
t
/p

=
(t-)
.

Proof
If output is constant, and a constant proportion of output is consumed, then the marginal utility is
constant, and the relative prices are determined by the discount factor. Therefore, the value of extending
credit to an entrepreneur who has a specific value for U is given by the solution to Equations (4) and (5).
This value is continuous and increasing in the coupon charged. If this value is less than x units of
consumption goods, then credit will not be extended. If this value is greater than x units of consumption,
then another venture capitalist would bid down the spread. Therefore, in equilibrium the coupon charged
by the entrepreneur ensures that the value of the relationship to the venture capitalist is equal to x units of
consumption goods.
As all cohorts of entrepreneurs are the same, the demand for new offices in each period would be the
same. All entrepreneurs have a positive probability of default in each period. Therefore, there will be a
steady state distribution of entrepreneurs, which implies that output will be a constant. Further, the
number of entrepreneurs being reviewed in each period is a constant as well.
In this equilibrium, a venture capitalist may choose to hedge a loan revealed as a high credit risk through
the review process. This outcome could occur even if the expected value of the output of the
entrepreneur is large. Therefore, there could potentially be a mutually advantageous renegotiation of the
loan terms after conducting the review. The entrepreneur could choose to counter offer so that s=PD/ (1-
PD), where the PD is determined using all information available to the entrepreneur and the venture
capitalist. The venture capitalist would be indifferent between accepting and rejecting the counter offer,
and we assume that he accepts it. The entrepreneur would only make such a counter offer if the expected
output of his production exceeds 1+s. As the venture capitalist does not derive any incremental benefit
from the counter offer, the value of the loan to the venture capitalist is still given by Equations (4) and (5).
This completes our outline of a proof.
Discussion
A reasonable question regarding this equilibrium: why doesnt another venture capitalist offer funding at a
lower spread to borrowers suspected of having a good review? One explanation: the fear of a bidding
war. If outside venture capitalist A offers a 3% spread to entrepreneur B, given credit at 4%, then venture
capitalist B could counter offer with better terms, or not, and venture capitalist A would either be a victim



of winners curse, or not. As long as venture capitalist A knows more about the entrepreneur than venture
capitalist B, then venture capitalist B can only lose a bidding war via Bertrand competition.
In this setting, the entrepreneur maintains the equity portion of the capital structure, and the venture
capitalist maintains the senior capital structure position (after paying the entrepreneur the retainer). This
specification helps keep the problem tractable. If the venture capitalist were to share in a portion of the
upside potential of the entrepreneurs output, then the decision to review the credit depends upon the
venture capitalists beliefs regarding the profit function of the entrepreneur, and the venture capitalists
decision to review the loan becomes more involved. Often, the venture capitalist receives equity in the
entrepreneurs firm, but not always. One should note that in this equilibrium, the amount of resources
devoted to a review is not likely to be optimal from the social planners perspective, as the value of the
review depends upon the upside potential of the entrepreneur, which the venture capitalist does not factor
into his decision to review the loan. This finding is reminiscent of Grossman and Stiglitz (1980), which
argues that competitive markets are intrinsically inefficient when information is costly.
Note, we assume the venture capitalist acts as if he is risk neutral, but not necessarily the entrepreneur,
and we do not explicitly specify how the entrepreneurs and venture capitalists income is distributed to
the representative agent. The venture capitalist acts to guarantee that the entrepreneur does at least as
well as his next best alternative, which is producing one unit of consumption goods for certain. One
justification for the venture capital acting in a risk neutral fashion could be diversification: the venture
capitalists risk can be diversified either by one venture capitalist funding many entrepreneurs or the
representative agents owning the income of many different venture capitalists.

5 An Example
In this section, we characterize the solution to the dynamic programming problem for three specific
scenarios. These examples allow us to demonstrate how the equilibrium spreads vary with credit risk in
different scenarios. They also allow us to show how both credit risk and model calibration influence
optimal review policy.
In the base case scenario, we calibrate the model to match the CAP curves and CDT used in Figure 2.
We construct the empirical reference points for this figure with respect to a one-year horizon. In this
section, we assume that the decision to review a loan is made once a quarter, and we choose parameter
values consistent with Figure 2 over a four-quarter horizon (i.e., a one-year horizon). We assume that the
public information variable (U) is fixed. We use a discrete approximation for a stochastic process to derive
a transition matrix for the time-varying private information (S
t
). We solve for the equilibrium spread that
sets the value of the relationship equal to a fixed percentage of the value of the principal (which would be
x in the context of Section 4).
Suppose the full information PD is given by:
( )
, 0 0
, ; , , ( )
FI t t t
PD U S N U S = + +

(6)
where U has a standard normal distribution independent of S
t
. We allow S
t
to vary with time, and S
t
is what
the credit analyst learns when conducting the review at time t. U is the public information. The private
information S
t
, follows a Ornstein-Uhlenbeck process that has a zero mean and an unconditional variance
of (2)
1
:
1

= +
t t t
dS S dW
where dW is a standard Wiener process.


This process is the continuous time analogue to an AR1 process, sometimes termed an elastic random
walk, in that S
t
is always being pulled back to the long term mean of 0 (c.f., Vasicek, 1977). Given S
t-x
, the
expectation and variance of S
t
are given by:
( )
exp( )

=
t t x t x
E S S S x and
( )
1 exp( 2 )
2

=
t t x
x
Var S S
Following the equilibrium defined in Section 4, the spread the lender pays the borrower on the loan, s, is
fixed, there is a fixed cost of review, CoR, and a fixed discount factor . In order to value a loan, one
needs the parameters {
0
, , ,}. Further, in order to use the setup of Equations (4) and (5) to solve for
the value of loan, one must be able to represent the evolution of the probability of default as a transition
matrix.
One can represent a discreet approximation to an Ornstein-Uhlenbeck process as follows. Subdivide a
time interval T into n equal partitions. Let the time increment,
n
, be defined as T/n. Define a step size as
=
n n
h , and a grid { } ..., 2 , , 0, , 2 ,...
n n n
h h h h =
n
X . If the probability of moving from x
i
to x
i
+1 is
equal to 0.5
2
i
x
h

+ and the probability of moving from x

i
to x
i-1
is given by 0.5
2
i
x
h

then this process

converges to an Ornstein-Uhlenbeck process with a mean of 0 and an unconditional variance of 1/(2) as
n goes to infinity (c.f., Stokey, 2009, pages 27-28). In order to specify this process as a transition matrix,
one first needs to define a state space with a finite number of elements. One approach is to choose the
smallest S
1
and the largest S
M
such that the state space contains plus or minus three standard deviations
of the unconditional variance of the process. Then the transition matrix, T, can be defined as
1
0.5
2
i ii
S
h

= + T for { } 2,..., i M ,
1
0.5
2
i ii
S
h

= T for { } 1,..., 1 i M ,
11
0.5
2
i
S
h

= + T ,
0.5
2
i MM
S
h

= T , and zero elsewhere. We use this transition matrix to build the transition matrix G.
The timing of events is important. We assume that T =1, and we interpret this time interval to represent a
quarter of a year. We assume that the probability of default within the quarter is determined by the state
at the beginning of the quarter. Further, the probability of transition from one state to another state
conditional upon not defaulting is represented by
n
T . We now construct the matrix G. Define the column
vector PD=[PD
FI
(S
1
), PD
FI
(S
2
), , PD
FI
(S
L
)]. Let 1 and 0 be row vectors of ones and zeros with M
elements, respectively. The transition vector G can then be constructed as:
( )
1
n
diag (
=
(

T 1- PD PD
G
0

The last row represents the probability of transitioning from default to another state, and the probability of
transitioning from a default state to a default state is 1. In order to ensure that the other rows sum to 1, we
must multiple each element of the matrix T
n
by one minus the probability of default, so that G
ij
now has
the interpretation of the likelihood of transition from state i to state j during the quarter and not defaulting.




Calibration
Table 2 Calibration Scenarios
Parameters Base Case
Strong
Private
Information
Weak
Public
Information

0
-3.27 -3.83 -2.98
0.85 1.34 0.52
0.27 0.60 0.62
0.16 0.16 0.16
Public Information AR 77.8% 77.8% 35.0%
Full Information AR 85.5% 93.0% 85.5%
CDT 2% 2% 2%
This frameworks calibration requires values for the parameters: {
0
, , , }. To a first order, the
parameter
0
determines the average default rate for the quarter, the parameter is the sensitivity of the
probability of default to public information, and the parameter is the sensitivity of the probability of
default to private information. The parameter determines the information decay rate. In Appendix B, we
argue that the parameter values for the base case in Table 2 are consistent with a CDT of 2% and a
public information accuracy ratio of 77.8%, a full information accuracy ratio of 88.5%, and the assumption
that private information decays over time with a half-life of four quarters.
9

Table 2 presents two other scenarios as well. In the second scenario, the private information is more
informative, in that the full information AR is 93%, but the public information is the same. In the third
scenario, the public information is weak; the public information AR is 35%, while the full information AR is
comparable to the base scenario.
We solve for the equilibrium spread for different scenarios under the assumption that the initial value of
the relationship is 2% of the principal, the cost of review is 0.5% of the principal, and the quarterly
discount factor is 0.98. We also look at the case where the cost of review is relatively small (0.10%) and
relatively large (2.0%). We present five different values of U: {-2,-1,0,1,2}.
Table 3 and Figure 3 below show the equilibrium spread for the three different scenarios. The first column
is the annualized probability of default. In all cases, the equilibrium spread increases in risk. Further, the
spread is positive for the safest names. In order for the value of the relationship to be 2%, a positive
spread is required.
10
The riskiest names have a spread less than the public information probability of
default. For the riskiest names, the strategy is to conduct the review, but only to extend credit if the
outcome of the review is favorable. Consequently, it can be profitable to review credits that look bad
under public information, given the market spread. The relationship between PD and the spread is the
steepest for the base case scenario. Under the base case scenario, the incremental predictive power of
the private information is the least; therefore, the equilibrium coupon better reflects the public information.


9
By a half-life of approximately four quarters, we mean that
4
( ) 0.5
t t t
E S S S
+
.
10
We compute equilibrium spreads as low as 20bps per annum or 5bps per quarter. The value of 5bps per quarter in
perpetuity discounted at 2% is about 2.5%, close to the minimum required value of the relationship.


Table 3 Equilibrium Spread (bps per annum) for a 0.50% COR
Base Case Base Case Base Case Base Case Strong Private Information Strong Private Information Strong Private Information Strong Private Information Weak Public Information Weak Public Information Weak Public Information Weak Public Information
U
Public
Information
PD Spread (bps)
Public
Information
PD Spread (bps)
Public
Information
PD Spread (bps)
-2 0.00% 23 0.00% 20 0.58% 51
-1 0.03% 41 0.01% 29 2.09% 71
0 0.51% 101 0.84% 57 6.13% 103
1 5.08% 288 13.21% 158 14.85% 158
2 26.58% 798 59.77% 489 29.83% 251


Figure 3 Spread and Public Information PD for different scenarios with a 0.5% review cost
Table 4 and Figure 4 present the equilibrium spread for the base case scenario under different review
costs. When the cost of review is low, the spreads are relatively flat, and the largest spread falls
significantly below the full information PD. In this case, the lender is likely to exercise their option to
review and choose not to extend credit, unless the review comes back favorably. As a result, spreads are
low for even borrowers whom appear very risky, but only the safe borrowers are extended credit. When
the cost of review is large, the spread profile becomes stepper, as reviews will be conducted less often,
making it necessary for the spread to better reflect the public information PD. The spread on the riskiest
loan remains less than the full information PD, which reflects that, for the high risk loans, the lender will
periodically exercise their option to review and only extend credit with a favorable review outcome.

0.01 0.10 1.00 10.00 100.00
0
100
200
300
400
500
600
700
800
900
1000
Public Information Annualized PD (%)
S
p
r
e
a
d

i
n

b
p
s

p
e
r

a
n
n
u
m
Spread and Public Information PD


Base Case
Strong Private
Weak Public




Table 4 Equilibrium Coupon and Public Information PD for Different Review Costs
U
Public
Information
PD 0.10% 0.50% 2%
-2
0.001% 19 23 36
-1
0.028% 29 41 69
0
0.512% 65 101 176
1
5.082% 166 288 509
2
26.582% 591 798 1475


Figure 4 Spread and Public Information PD for Different Review Costs


0.01 0.10 1.00 10.00 100.00
0
200
400
600
800
1000
1200
1400
1600
Public Information Annualized PD (%)
S
p
r
e
a
d

i
n

b
p
s

p
e
r

a
n
n
u
m
Spread and Public Information PD


Base Case & COR is 10bps
Base Case & COR is 50bps
Base Case & COR is 200bps



Figure 5 Value of the Relationship and Time to Next Review for the Base Case with a 0.50% Cost of Review
The top panel of Figure 5 presents the equilibrium spreads for different values of U (public information) as
vertical lines. The middle panel presents time to review against the full information PD for different values
of U. The bottom panel represents the loan value expressed as a percentage of the principal. For all
values of U, the value of the relationship obeys a smooth pasting condition where, as the full information
PD becomes large, the value becomes close to zero, and the derivative of the value of the loan with
respect to the full information PD approaches zero. The time to the next review has a U-shaped
relationship with the outcome of the last review. The riskiest loans are potentially the most valuable, but
are also the most sensitive to the review outcome. The safest loans are relatively insensitive to the full
information PD, because the credit risk component of the loan is small relative to the coupons information
0.001 0.01 0.10 1.00 10.00
0
10
20
30
40
Full Information PD and Value of Relationship
V
a
l
u
e

o
f

R
e
l
a
t
i
o
n
s
h
i
p

(
%
)
Full Information Annualized PD (%)
0.001 0.01 0.10 1.00 10.00
0
5
10
15
20
Full Information PD and Time to Next Review
T
i
m
e

t
o

N
e
x
t

R
e
v
i
e
w

(
Q
T
R
S
)
0.001 0.01 0.10 1.00 10.00
0
5
10
15
20
Equilibrium Annualized Spread


U of -2
U of -1
U of 0
U of 1
U of 2



cost. Consequently, the riskiest loans are reviewed the most often. A relationship with a high risk
borrower (according to public information) can be rather valuable, if the review comes back favorable.
In contrast to the single period case, the loans one is indifferent to holding are not the loans reviewed
most often. The intuition follows. Conditional upon extending credit, the expected cash flows within the
current period are a concave function of S
t
( Figure 2 shows that the downside losses are bigger than the
upside returns). As time passes and a review is not conducted, S
t
becomes more uncertain, and the
expected value of cash flows declines, one may choose not to extend credit, but the value of resolving the
uncertainty in S
t
increases, making the review more valuable. If the expected cash flows are very close to
zero but positive during the current period, the optimal strategy is to extend credit today, not extend credit
during the next several periods, and wait until enough time passes so that S
t
may improve enough to pay
for the cost of the review. If the review outcome is favorable, one extends credit again.

6 Value of a Review in a Dynamic Setting
An important question remains: how much economic value does pursuing an optimal review strategy
create? In the dynamic setting, one can express the value of pursuing an optimal review strategy as the
difference between the value of the relationship under the optimal review strategy and the value of the
relationship if the lender pursues some other policy. In this section, we use reviewing each borrower
every four quarters as the alternative strategy. One reason for choosing this strategy as a reference point
is that often regulatory guidelines require an annual review. Also, the work flow of the review process is
often tied to the receipt of the new, full-year financial statements.
We solve for the value of the relationship under a fixed annual review policy by setting every element of R
to 4 in Equations (4) and (5), and we place a lower bound of 0 on the value of the relationship. We then
iterate to solve for the value of the relationship for every value of S. The lower bound of 0 has the
interpretation that, if the cost of reviewing the loan once a year exceeds the potential upside associated
with extending such a borrower credit, then the lender will walk away from the relationship, and they will
no longer be required to review the borrower every year. This places a smooth pasting condition on the
value of the relationship under a fixed review cycle: As S becomes larger, the value of the relationship
approaches zero, and the change in the value of the relationship with respect to S approaches zero.
We examine the value of the review under the base case with a 50bps cost of review. We focus on a firm
with a U of 1, which corresponds to a PD based on public information of 5.1% and a spread of 288bps
( Table 3). We focus on a U of 1, because it is often optimal to review more often than every four quarters
for this level of risk ( Figure 5). In this case, the incremental value of the review is likely elevated.
The top panel of Figure 6 compares the optimal review policy for different full information PDs with the
every four quarters rule. The middle panel shows the value of the relationship under the optimal policy
and the value under the every four quarters rule. The bottom panel shows the difference between the two,
the value of pursuing an optimal review policy. For a full information PD of 0.73%, the value of a mid-year
review equals 1.32% of the exposure size. The incremental value of an optimal review policy is humped
shaped. For the safer firms, time to the next review is four quarters, so the optimal policy corresponds
with the fixed review cycle, and the difference in value is smaller. For the riskiest firms, both value
functions asymptote to zero, which results in small differences as well.



Figure 6 Value of a Review in a Dynamic Setting
Table 5 provides the numbers behind Figure 6. It also provides the Normalized S, which is S divided by
its unconditional standard deviation. The excess annualized spread on the loan is provided (the
annualized spread less the full information annualized PD). Note that the excess spread is negative for a
positive S, which implies that one-half of the borrowers in this risk group will not receive credit after
completion of their review. Also, note that the value of the review peaks for a normalized S of -1.38. This
implies is that the incremental value of an optimal review is greatest for the borrowers whom are relatively
risky according to public information (a 5.3% PD according to public information), but much less risky
according to full information (a 0.73% full information PD). In this case, the optimal strategy is a mid-year
review, which generates 1.32% of value relative to the size of the exposure.

0.1 1
0
5
10
15
Different Review Strategies
T
i
m
e

t
o

N
e
x
t

R
e
v
i
e
w

(
Q
T
R
S
)


Optimal Review Strategy
Review Every 4 Quarters
0.1 1
0
5
10
15
20
Value of Different Review Strategies (%)
V
a
l
u
e

o
f

t
h
e

R
e
l
a
t
i
o
n
s
h
i
p
0.1 1
0
0.5
1
1.5
Difference in Value of Review Strategies (%)
Full Information Annualized PD (%)
D
i
f
f
e
r
e
n
c
e

i
n

V
a
l
u
e



Table 5 Value of a Review in a Dynamic Setting
Normalized
S
Annualized
Full
Information
PD (%) Time To Next Review Value of Relationship (%)
Annualized
Excess
Spread (Bps)
Optimal Constrained Optimal Constrained Difference
-2.07 0.32 3 4 12.51 11.52 0.99 255.2
-1.90 0.40 3 4 11.21 10.11 1.10 247.7
-1.72 0.49 2 4 9.80 8.60 1.20 238.5
-1.55 0.60 2 4 8.33 7.03 1.29 227.6
- -- -1.38 1.38 1.38 1.38 0.73 0.73 0.73 0.73 2 22 2 4 44 4 6.82 6.82 6.82 6.82 5.51 5.51 5.51 5.51 1.32 1.32 1.32 1.32 214.5 214.5 214.5 214.5
-1.21 0.88 2 4 5.34 4.12 1.22 198.8
-1.03 1.07 2 4 3.95 2.92 1.03 180.1
-0.86 1.28 4 4 2.79 1.89 0.90 158.0
-0.69 1.54 9 4 1.96 1.07 0.88 131.9
-0.52 1.84 14 4 1.39 0.47 0.92 101.2
-0.34 2.19 20 4 0.96 0.06 0.90 65.2
-0.17 2.60 26 4 0.61 0.00 0.61 23.1
0.00 3.08 33 4 0.38 0.00 0.38 -25.8
0.17 3.63 40 4 0.25 0.00 0.25 -82.5

In this section, we demonstrated the value of the review by contrasting the value of the relationship under
an optimal review cycle versus a fixed review cycle. The value of the review is largest when the optimal
strategy is to review the loan more often than each year. It is also largest when the public information
implies a highly elevated risk level relative to the full information PD.


7 Conclusion
This paper presents a basic framework for computing the value of a credit review. Our framework is
consistent with some basic characteristics of PDs. For example, the distribution of PDs in a portfolio
typically skews to the right as default probabilities are bounded between 0 and 1, and the largest PDs in a
population are typically many times larger than the CDT.
Our core assumption is that the outcome of the credit review is a full information PD with better
discriminatory power than a partial information PD, and the full information PD leads to a decision on
whether or not to sell the loan. In this framework, the relationship between the value of a review and the
characteristics of the exposure is multidimensional: it depends on the partial information PD, the spread,
the hedging costs on the loan, the central default tendency, and the accuracy ratios of the full and partial
information PDs. Simple policy rules, such as review each loan each year or review each loan whose PD
moves outside a certain threshold range, applied without regarding to the spread on the loan, are not
optimal within this framework.


For reasonable baseline parameters, the value of a review can be as high as 200bps. In general, the
value of a review is lower when the decision to hedge (or not) is a foregone conclusion. The highest
values of a review occur near the point where the lender is indifferent between hedging and not hedging,
given partial information. Holding the excess spread constant, the value of a review increases as the
partial information probability of default increases.
Our framework provides a theoretical interpretation for practices found in the review process. For certain
credit classes, a financial institution may take action without a formal review, based on the outcome of a
quantitative scoring model (e.g., a pre-approved credit card), whereas, for other asset classes, an action
is never taken solely on the basis of a quantitative scoring model (e.g., the renewal of a line of credit to a
large corporation). As the cost of review per unit of exposure is likely higher in consumer credit than
corporate credit, different practices could be justified within this framework. Another common practice is to
watch list the riskiest loans and review them more often. In this framework, one should review loan A
more often than loan B if it is riskier and both are in the portfolio (spread exceeds expected loss under
partial information) and pay the same spread. Therefore watch listing the riskiest credits can be justified
under this framework.
The realized value of a review for a good credit (one for which the excess spread is positive) is
asymmetric. In most cases, the ex post value of a review equals zero. Most reviews determine that the full
information PD is less than the partial information PD, and no action is taken on the loan. In some cases,
however, the full information PD turns out to be worse than the partial information PD, enough worse that
the institution acts on the loan. In these relatively rare cases, the savings to the lender are substantial. As
a result, one can underestimate a reviews value if looking at the ex post realized values on a relatively
small sample. This scenario speaks to the difficulty of properly assessing the value that analysts bring to
managing a credit portfolio.
We show how the framework can be extended to incorporate a time dimension and show how it can be
embedded in a competitive equilibrium, in which prices reflect public information. In this setting, we
compute the partial information PD utilizing public information and the full information PD utilizing
both public information and private information. The relevance of the information acquired during a
review process decays with time. The optimal time until the next review depends on the spread on the
loan, the cost of the review, the public information on the borrower, and the outcome of the most recent
review. It also depends on the characteristics of the asset class: how informative is the partial information
PD? The full information PD? How fast does information acquired during the review process change? For
reasonable parameter values, it may be optimal to review the loan during the next quarter and, in other
cases, it may be optimal to rely solely upon public information. In the dynamic setting, the spread on a
loan is more closely tied to the public information PD when the cost of review is higher or the incremental
information content of private information is smaller.
We assess the value of an optimal review policy by comparing it to a fixed review cycle of once every four
quarters. We show that the incremental value of the review is largest for the loans that should be
reviewed more often than every four quarters. In fact, the value of a mid-year review can be as much as
1.3% of the exposure amount.



Appendix A Table of Symbols

Symbol Meaning
PD Probability of Default
X Row Vector of both partial and full information default drivers

0
and The intercept and a column vector of coefficients for the full information PD
Y and Z The partial information and full information default drivers
and The coefficients for the partial and full information default drivers
CDT The average default rate of the population
and
0

The coefficient for the partial information driver and the intercept under partial
information
CAP and AR Cumulative Accuracy Profile and Accuracy Ratio
s and h The spread on the loan and the transaction cost of selling
Dynamic Version of the Framework
S
t
The time-varying private information
U The public information that is fixed for each borrower
The discount factor
N The number of possible values for S (including the absorbing state)
D
t
A row vector representing the distribution of a borrower across different states
from the perspective of the lender
D(i) A row vector of zeros except for a one at the ith element. Indicates that a
borrowers current value of S is S
i

and G For a given borrower, represents the transition matrix governing the evolution
of S (the private information). G is the calibrated version of this matrix employed
in Section 5.
CoR and s The cost of review and spread on the loan
R and V Column vectors representing the number of periods until the next review and the
value of the option to lend for each possible value of S
and The parameters governing the sensitivity of the PD to the public information, U
and private information, S
t

The parameter governing the persistence of the private information


Appendix B The Distribution of PDs and CAP Curves
In this Appendix, we show how to derive the distribution of the partial information PDs and the full
information PDs. We also derive an expression for the Cumulative Accuracy Profile (CAP curves) and the
corresponding Accuracy Ratio (AR). These constructs allow us to calibrate the parameters using
empirical reference points. We show how the framework enables comparative statics that change the
partial information AR, while holding the full information AR constant and vice versa.
In validating a PD model, key workhorses are CAP curves and their corresponding ARs.
11
These
constructs assess a credit risk measures ability to rank order firms in terms of separating out the bad
borrowers from the good borrowers. CAP curves are typically defined with respect to a specific sample. In
this section, we work with the population analogues to these measures. The cumulative accuracy profile
(CAP plot) of a credit risk measure can be defined as:
1
0 0 0
( ) ( ) ( ) ( )
q q
CAP q D x dx D x dx D x dx CDT = =


Where D(q) is defined as follows. Consider a small interval, (q, q+), which is a subset of [0,1]. The
portion of the exposures in the population riskier (according to some credit risk measure) than the
exposures within the interval is q. The portion of the exposures in the population safer than the
exposures within the interval is q+. D(q) is defined to provide the rate at which exposures in this interval
default:
( ) ( )
0
( ) lim ( )
q
q
D q D x dx

. The Accuracy Ratio is defined as

1
0
( ) 0.5
0.5(1 )
CAP q dq
AR
CDT

.
The AR is the ratio of the area between the CAP Curve and the 45 degree line, divided by the area
between the CAP Curve of a Perfect Model and the 45 degree line. A perfect model has an AR of 1, and
a random model has an AR of 0.
In our context, for the full information PD,
1
( ) N PD

has a normal distribution with a mean of

0
and a
variance of ' . Therefore, the quantile function of the full information PD is given by:
( )
1
0
( ) ( ) '
FI
F q N N q

= +

This function takes a percentile as an input and produces the PD associated with that percentile. For
example, if q=0.975, then 97.5% of the population has a PD less then F
FI
(0.975). It is convenient to define
PD
FI
(q) = 1-F
FI
(q), so that PD
FI
(0.025) has the interpretation that 2.5% of the population has PD of greater
than PD
FI
(0.025). By symmetry of the normal distribution, we see that:
( ) ( )
1 1
0 0
( ) 1 ( ) ' ( ) '
FI
PD q N N q N N q

= + = +

Note that in this context, PD
FI
(q) is the D(q) used above in defining a CAP curve. Therefore, the CAP
curve for the full information PD is given by:
( )
1
0
0
( ) ( ) '
x
FI
CAP x N N q dq CDT

= +

11
Some analysts use Receiver Operating Characteristic curves and Gini Coefficients. Engelmann et. al., (2003)
provide a description of the concept of a Cumulative Accuracy Profile, an Accuracy Ratio, and their relationship to
Receiver Operator Characteristic curves. A note by Andrew Curtiss (2009) proves the equivalence of an Accuracy
Ratio and a Gini Coefficient.



We evaluate this function using numerical integration. Computing the corresponding AR involves
evaluating a double numerical integral.
This result is useful for conducting comparative statics on the framework. For example, suppose we fix
2 2
+ at
2
B and
0
at
1 2
( ) 1 N CDT B

+ . For any given , we can solve for

2 2
B = such that
the full information CAP curve, the full information AR, and the CDT are the same (provided is less than
B), but the partial information AR changes. The left-hand panel of Figure 7 shows how the CAP curve of
the partial information PD can change, while the full information CAP plot remains constant. As the partial
information PD becomes more informative, the partial information CAP curve approaches the full
information CAP curve.

Figure 7 Changing CAP Plots with Model Parameters
By identical arguments, the quantile function of the partial information PD is given by:
( )
1
0

( ) ( ) '
PI
F q N N q

= +
and the partial information CAP plot is given by:
( )
1
0
0

( ) ( ) '
q
PI
CAP q N N x dx CDT

= +

Therefore, if we change and in such a way that holds
' ,
0

and CDT constant, then we change

the discriminatory power of the full information PD without changing the discriminatory power of the partial
information PD.
For example, fix
0

at
0
2 2
0 0
1
B
+ +
and
2
0

1
G

=
+
. For any positive , if
2
2
0
1
1
G

+
=
+
and
1 2 2
0
( ) 1 N CDT

= + + then the partial information CAP plot, the partial information AR, and the
CDT remain constant, but the full information AR increases in . The right-hand panel of Figure 7 shows
how the full information PD CAP curve changes while the partial information PD CAP plot remains
constant. The full information PD CAP curve approaches the CAP curve of a perfect model as the full
information PD becomes more informative.
0 20 40 60 80 100
0
10
20
30
40
50
60
70
80
90
100
Percent of Population
P
e
r
c
e
n
t

o
f

D
e
f
a
u
l
t
s
Changing Paritial Information
0 20 40 60 80 100
0
10
20
30
40
50
60
70
80
90
100
Percent of Population
P
e
r
c
e
n
t

o
f

D
e
f
a
u
l
t
s
Changing Full Information


Appendix C Calibration
In Section 3, we state that specific values of
0
{ , , , } imply specific values for the CDT, partial
information AR, and full information AR at one-year horizon. In this section, we describe the calibration
procedure used to make this assertion. We make three assumptions. First, we assume a specific
distribution of the private information (S) of entrants, given their public information (U). Second, in order
for a steady state to exist, it is necessary that all firms have a positive probability of default. Third, we
compute the average CDT, partial information AR, and full information AR, with respect to the whole
population, without regard to whether or not they are actually extended credit.
We describe a procedure that takes as inputs
0
{ , , , } and produces {CDT, AR
PI
,AR
FI
} at the one-
year horizon. In order to do so, we need to compute a steady state distribution of firms in terms of U and
S. We then must compute the partial and full information probability of default at a one-year horizon.
Finally, we must compute the average default rate, cumulative accuracy profiles, and the corresponding
accuracy ratios. Once we define the function, we can compute the parameters
0
{ , , , } that are
consistent with the desired {CDT, AR
PI
,AR
FI
} by minimizing a loss function.
First, we approximate a standard normal distribution using a binomial distribution. Specifically, U can take
on values of { 0 , 1 ,..., 24 } U where the probability that U takes on the value U
i
is
25
1 1
25 2 2
i i
i

| |
| | | |
| | |
\ \
\
. We set { } , to ensure that U will have a mean of zero and a variance of 1.
For each value of U, we solve for the steady state distribution of S as follows. First, we assume that there
are entrants in each period. The new entrants are distributed according to the unconditional distribution of
an Ornstein-Uhlenbeck process using a discrete approximation. Using an n of 20, this is easily computed
as the first row of T
500
, where T is the transition matrix defined in Section 5. Let E be this row vector with a
0 added to the end to represent the absorbing state (i.e., firms in the default state do not enter).
For each value of U, we utilize
1
i
U
i

EG to compute the steady state distribution. Note that each term in

the sum is a row vector that represents distribution in the current period of the cohort that entered i
periods ago. Finally, we convert it into a distribution by setting the population in the absorbing set to 0 and
then normalizing so that the row vector sums to one. Let SS
U
be the steady state distribution associated
with a specific value of U.
We now have the state steady distributions for both S and U. Given {U,S}, the one-year full information
probability of default is given by the last element of DG
U
4
, where D is a row vector of zeros, with a 1
indicating the current values of S and G
U
is the transition matrix associated with the specific value of U.
For a given U, the public information probability of default is given by the last element SS
U
G
U
4
. The
average default rate of the population can be computed as either the weighted sum of public information
probabilities for each value of U or the weighted sum of the full information one-year default probabilities
for each value pair of {U,S}. For the public information case, the weights are given by the binomial
distribution. For the full information case, the weights are the product of the probability of U
i
and the
probability of S
i
given U, where the later is given by the steady state distribution of S given U. The
computation of the partial information AR and the full information AR are then computed using the
discrete analogues to the definitions provided in Appendix C. By treating as fixed, we can solve for the
values of
0
{ , , } that produce specific values of {CDT, AR
PI
, AR
FI
} by minimizing a loss function.





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