Our analysis documents that the existence of hidden “holes” in the capital of not yet failed banks - while creating intertemporal pressure on the actual level of capital - leads to changing of maturity of loans supplied rather than to contracting of their volume. Long-term loans decrease, whereas short-term loans rise - and, what is most remarkably, by approximately the same amounts. Standardly, the higher the maturity of loans the higher the credit risk and, thus, the more loan loss reserves (LLP) banks are forced to create, increasing the pressure on capital. Banks that already hide “holes” in the capital, but have not yet faced with license withdrawal, must possess strong incentives to shorten the maturity of supplied loans. On the one hand, it raises the turnovers of LLP and facilitates the flexibility of capital management; on the other hand, it allows increasing the speed of shifting of attracted deposits to loans to related parties in domestic or foreign jurisdictions. This enlarges the potential size of ex post revealed “hole” in the capital and, therefore, allows us to assume that not every loan might be viewed as a good for the economy: excessive short-term and insufficient long-term loans can produce the source for future losses.
Credit risk in derivative securities: A simplified approach