Banking in a Volatile World: Setting Country Lending Limits

Abstract

Banks often make decisions in an organizational framework that attempts to control repayment problems by setting loan limits for each country. A formal mechanism for setting those limits will be proposed. Our motivation is twofold. From the point of view of the lending institution, a more formal decision making system may be desirable. For the purpose of bank regulation this research offers help in quantifying and comparing the risk levels of banks. Country risk analysis has traditionally tried to articulate all the risks associated with a country. This is suspect in light of modern financial theory which holds that investors are rewarded primarily for bearing systematic, or market risk. This paper suggests several measures of risk and reward in international lending markets. First we model this situation with a multicriterion linear programming problem. After finding some drawbacks of that approach we propose a simpler alternative which is consistent with the Capital Asset Pricing Model (Sharpe, 1981). Beta, a measure of systematic risk, is estimated for countries. It is used as an input to a series of constrained optimization problems whose output is country lending limits.