Research Discussion Papers, Bank of Finland
No 2/2000:
A Model for Estimating Recovery Rates and Collateral Haircuts for Bank Loans
Esa Jokivuolle ()
and Samu Peura ()
Abstract: We present a model of risky debt in which collateral value
is correlated with the possibility of default. The model is then used to
study: 1) the expected amount of debt recovered in the event of default as
a function of collateral; and 2) the amount of collateral needed to
mitigate the riskiness of a loan to a desired degree. The results obtained
could prove useful for estimating recovery rates required by many popular
models of credit risk and for determining collateral haircuts in debt
transactions. The analysis also generates testable predictions of the
behaviour of historical recovery rates of risky debt when collateral is
involved. Regulators might benefit from the analysis in developing capital
adequacy requirements and reviewing banks' lending standards relative to
current collateral values.
Keywords: credit risk; collateral; recovery rates; options theory; (follow links to similar papers)
JEL-Codes: G13; G21; (follow links to similar papers)
22 pages, March 14, 2000
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