Loan Portfolio Management in the Paradigm of Leveraged Risk, Liquidity Risk and Limited Liability

Abstract

In the context of a loan portfolio, banks and other financial institutions are subjected to Limited Liability protection. However, in most of the model formulation, this protection is not taken into consideration. Accordingly, in order to address this gap, we have focused on incorporation of Limited Liability in the model paradigm. We begin by considering four models, one for maximizing expected return and the other with minimization of risk (with a threshold of expected return), both for the scenarios of including and excluding Limited Liability. Our theoretical results show that the solutions of the models with Limited Liability produce better results than the others, in terms of both maximizing expected return and minimizing risk. More specifically, the portfolios that included Limited Liability are less risky as compared to the portfolios that did not include Limited Liability. An illustrative example is presented to support the theoretical results obtained.