Credit rationing - Wikipedia, the free encyclopedia. Credit rationing refers to the situation where lenders limit the supply of additional credit to borrowers who demand funds, even if the latter are willing to pay higher interest rates.
Credit Rationing in Markets with Imperfect Information. Created Date: 11/23/2010 7:19:18 PM. The main distinguishing factor between equilibrium and disequilibrium rationing in the credit markets is. It is an example of market imperfection, or market failure, as the price mechanism fails to bring about equilibrium in the market. It should not be confused with cases where credit is simply . On the contrary, the borrower would like to acquire the funds at the current rates, and the imperfection refers to the absence of equilibrium in spite of willing borrowers. In other words, at the prevailing market interest rate, demand exceeds supply, but lenders are not willing to either loan more funds, or raise the interest rate charged, as they are already maximising profits. In that case, shortages lead governments to control the food portions allocated to individuals, who would be willing to pay higher prices for more portions. However, credit rationing is not necessarily the result of credit shortages but rather of asymmetric information. More importantly, food rationing is a result of direct government action, while credit rationing is a market outcome. Three main types of credit rationing can usually be distinguished: The most basic form of credit rationing occurs if the borrower cannot provide sufficient collateral. Collateral is important because repayment promises are not credible per se. Therefore, lenders require mortgages, reservations of property rights, or security assignments as collateral. Plunges in collateral values enhance credit rationing. More importantly, they would not be able to get loans even if they were willing to pay higher interest rates. Market equilibrium occurs when the demand of a good at the equilibrium price is equal to the supply of the good. If prices are deemed . On the other hand, if prices are . The interest rate is denoted by r, and S and I denote savings and investment respectively. This is a highly stylised example, where one abstracts from changes in output, and where the economy is in financial autarky (and, consequently, savings and investment express the supply and demand of loanable funds, respectively). Equilibrium will be attained at the point where S=I, at the equilibrium interest rate r*. At r> r*, credit is . The interest rate will have to fall in order to clear the market. Disequilibrium credit rationing. This could be either because of some friction in the market, or some government policy (such as anti- usury laws), which prevent supply and demand from being equalised. The main distinguishing factor between equilibrium and disequilibrium rationing in the credit markets is that the latter is not a long term feature, and can be alleviated through changes in policy or simply through time, and does not necessarily reflect chronic or structural features of the credit market. The most important contribution in this vein was by Dwight Jaffee and Franco Modigliani. Stiglitz and Weiss developed a model to illustrate how credit rationing can be an equilibrium feature of the market, in the sense that the rationed borrower would be willing to obtain the funds at an interest rate higher than the one charged by the lender, who will not be willing to lend the extra funds, as the higher rate would imply lower expected profits. It is equilibrium rationing as there exists excess demand for credit at the equilibrium rate of interest. The reason for that is adverse selection, the situation where the lender is faced with borrowers whose projects imply different risk levels (types), and the type of each borrower is unbeknownst to the lender. The main intuition behind this result is that safe borrowers would not be willing to tolerate a high interest rate, as, with a low probability of default, they will end up paying back a large amount to the lender. Risky types will accept a higher rate because they have a lower chance of a successful project (and typically a higher return if successful), and thus a lower chance of repayment. Note that this assumes limited liability, though results could still hold with unlimited liability. Pure credit rationing. Let there be two types of individuals, who are observationally identical, and only differ in the riskiness of their projects. Assume type A individuals are low risk compared to type B, in the sense that the expected return on type B projects is a mean preserving spread of type A projects; they have the same expected return, but higher variance. For example, imagine that type A returns are uniformly distributed (meaning that all possible values have the same probability of occurring) from $7. A projects is at least $7. Now, assume type B project returns are also uniformly distributed, but their range is from $5. Type B project returns also have an expected value of $1. Now assume that the bank knows that two types exist, and even knows what fraction of the potential borrowers applying for loans belong to each group, but cannot tell whether an individual applicant is type A or B. The implication to the bank of the difference in the riskiness of these projects is that each borrower has a different probability of repaying the loan, and this affects the bank's expected return. The bank would thus like to be able to identify (screen) the borrower types, and in the absence of other instruments to do so, it will use the interest rate. This was the main intuitive observation of Stiglitz and Weiss. They realised that an individual that is willing to accept a higher interest rate in her loan is doing so because she knows that the riskiness of her project is such that there is lower probability of repaying the loan. In a limited liability setting, where the personal assets of the borrower might not be taken as collateral, the borrower might not object to paying a high enough interest rate, as she knows that the probability of the project succeeding is low, so probability of repayment is low. Even if the project does succeed, the returns will be high enough for a profit to be left after repaying the loan. In fact, as interest rates rise, the critical value of the project (think of it as expected return), above which the borrower is willing to borrow the money, also rises. Naturally, there exists a (higher) cut off point for the risky types as well, above which even they would not be willing to borrow. This situation should show that the interest rate has two effects on banks' expected return. On the one hand, higher interest rates imply that, for a given loan, the repayment (if it does take place) will be higher, and this increases bank profits; this is the direct effect. On the other hand, and crucially for credit rationing, a higher interest rate might mean that the safe types are not anymore willing to accept the loans, and drop out of the market; this is the adverse selection effect. These two effects together give an odd shape to the bank's expected return. It is strictly rising with the interest rate when the latter is low enough; at the point where the safe types drop out of the market (call it r. Technically speaking, the expected return is non- monotonic in the interest rate, as it rising, then falling sharply, then rising again until it falls sharply to zero. It follows then that if the level of the interest rate that maximises the bank's expected return is lower than the level after which risky types drop out, there might be credit rationing, if the supply of funds is low enough. If the optimal rate (from the point of view of the bank) is between r. If the optimal rate is below r. It might be more intuitive to imagine a situation with a very large number of types (continuum). In that case, the expected return function of the bank will become smooth, rising for low levels of the interest rate, until the optimal rate, and then falling smoothly until it reaches zero. Types that would be willing to borrow at rates higher than the optimal might be rationed. It is important to note that as the supply of funds to the bank rises, some of the rationed people will get a loan, but at the same interest rate, which is still at the profit maximising level. For a sufficient rise in supply, everyone will receive loans, at which point the interest rate will have to fall. Finally, if the optimal rate is high enough, we might have no rationing. This will happen if the level of the interest rate such that current supply of funds equal demand for funds is lower than the optimal rate, and equal to r. In fact, the bank can perfectly distinguish between the different types of buyers according to some criterion. Each type is assumed to have a different expected return function (from the point of view of the bank). As an illustration, consider the case of three types, 1, 2 and 3, which are ranked according to the maximum expected return they give to the bank, from lowest to highest. The maximum expected return a type 3 borrower can give to the bank (at the optimal interest rate for the borrower) is higher than that of type 2, which is higher than that of type 1. For a sufficiently high cost of obtaining funds, only type 3 borrowers will receive credit. This will occur if the maximum expected return from type 2 borrowers is lower than that cost. If costs fall by enough, type 2 borrowers will obtain credit, and if they fall further so will type 1 borrowers. Every type that receives credit will be charged different interest rates, but the expected return to the bank will be equal for each type, as long as there is competition between banks. It is important to note that type 1 borrowers obtain credit only if type 2 borrowers are not rationed, and so on. This argument is quite pertinent in the context of the subprime mortgage crisis. Low interest rate setting by the Federal Reserve made the cost of loanable funds extremely low.
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