TAILIEUCHUNG - Illiquidity Component of Credit Risk

In a third step, the firm now uses the money to hire some formerly unemployed worker from the household sector in order to produce some capital good (. build a factory building). Hiring the worker and paying him 100 pesos by bank transfer means a transfer of the deposit from the firm’s account to the household’s account in the bank. 12 At the same time, the firm gets the capital good newly produced while the household’s net wealth increases by the amount of wages paid (accounting record 3). Thus, the capital stock has been increased just by employing formerly underutilized. | Illiquidity Component of Credit Risk Stephen Morris Princeton University smorris@ Hyun Song Shin Princeton University hsshin@ first version March 2009 this version September 2009 Abstract We describe and contrast three different measures of an institution s credit risk. Insolvency risk is the conditional probability of default due to deterioration of asset quality if there is no run by short term creditors. Total credit risk is the unconditional probability of default either because of a short term creditor run or long run asset insolvency. Illiquidity risk is the difference between the two . the probability of a default due to a run when the institution would otherwise have been solvent. We discuss how the three kinds of risk vary with balance sheet composition. We provide a formula for illiquidity risk and show that it is i decreasing in the liquidity ratio - the ratio of realizable cash on the balance sheet to short term liabilities ii increasing in the outside option ratio - a measure of the opportunity cost of the funds used to roll over short term liabilities and iii increasing in the fundamental risk ratio - a measure of ex post variance of the asset portfolio. We thank Pete Kyle Kohei Kawaguchi and Yusuke Narita for their comments as discussants on this paper. We are grateful to Sylvain Chassang Masazumi Hattori Chester Spatt Wei Xiong and workshop and conference participants at many institutions for their comments on earlier versions of this paper and to Thomas Eisenbach for research assitance on the project. We acknowledge support from the NSF grant SES-0648806. 1 1 Introduction Credit risk refers to the risk of default by borrowers. In the simplest case where the term of the loan is identical to the term of the borrower s cash flow credit risk arises from the uncertainty over the cash flow from the borrower s project. However the turmoil in credit markets in the financial crisis that erupted in 2007 has highlighted the .

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