Managing Credit Risk

Recall that Carson Company relies heavily on commercial banks for loans. When the company was first established with equity funding from its owners, Carson Company could easily obtain debt financing because the financing was backed by some of the firms assets. However, as Carson expanded, it continually relied on extra debt financing, which increased its ratio of debt to equity. Some banks were unwilling to provide more debt financing because of the risk that Carson would not be able to repay additional loans. A few banks were still willing to provide funding, but they required an extra premium to compensate for the risk.

a. Explain the difference in the willingness of banks to provide loans to Carson Company. Why is there a difference between banks when they are assessing the same information about a firm that wants to borrow funds?

b. Consider the flow of funds for a publicly traded bank that is a key lender to Carson Company. This bank received equity funding from shareholders, which it used to establish its business. It channels bank deposit funds, which are insured by the Federal Deposit Insurance Corporation (FDIC), to provide loans to Carson Company and other firms. The depositors have no idea how the bank uses their funds. Yet, the FDIC does not prevent the bank from making risky loans. So who is monitoring the bank? Do you think the bank is taking more risk than its shareholders desire? How does the FDIC discourage the bank from taking too much risk? Why might the bank ignore the FDICs efforts to discourage excessive risk taking?