The traditional market with perfect information leads to an equilibrium point, which can be found at the intersection of demand and supply functions. Nevertheless the analysis of credit markets has shown that market agents, particularly banks, are not interested in reaching equilibrium. The behaviour of the banks is widely recognised as credit rationing and can be described as a situation in which lenders do not raise interest rates to clear excess demand. Despite the substantial body of academic literature on the topic there is no final agreement on what actually causes credit rationing. The following paper attempts to compare different theories and models, particular focus is given to market imperfections.
Generally accepted terminology defines credit rationing as a situation in which demand for commercial loans exceeds the supply of these loans at the commercial loans rate quoted by banks. (Cosci, 1992) Widely cited research by Stiglitz and Weiss (1981) distinguishes two accepted types of credit rationing:
First type is described as a situation where some of the loan applicants receive a loan and other applicants, that appear equal, do not receive a loan even when they offer to pay higher interest rates
Second type is the situation where some individuals are unable to get a loan under one supply schedule at any interest rate, but they would be able to get a loan under a larger schedule. The following research focuses on the second form of the credit rationing.
In the world with perfect and costless information, banks would specify all action that might be undertaken by borrowers Stiglitz and Weiss (1981). However in reality banks are not able to control the actions of their borrowers. Since information on behaviour of the bank clients is not perfect and is asymmetrically distributed in the credit market, it is crucial for banks to consider possible actions that borrowers can take (Cosci, 1992). One of the widely used policies of the banks is to strictly specify terms of the loan contract in an attempt to induce the borrower to take actions which are not in the interests of the bank, as well as to attract clients that have low risk of defaulting payments. According to Stiglitz and Weiss (1981) such policy may result in a situation where bank returns increase less rapidly than interest rates, and might even decrease beyond a certain bank optimal rate r* (Figure 1). The price mechanism may not clear the loan market if interest rates go above r* since the bank would be attracting worse risk. In banks judgment, individuals who are ready to pay more than r* are likely to have higher risk compared to other customers. Hence the banks best strategy is to ration credit whenever demand pushes interest rates up. As it follows a competitive equilibrium in the loan market may be characterised by credit rationing.
Figure 1. There exists an interest rate which maximizes the expected return to the bank Stiglitz and Weiss (1981).
Analysis of ex-ante and ex-post asymmetric information models
The information theories of credit rationing make alternative assumptions: ex-ante asymmetric information or ex-post asymmetric information. Models, which consider ex-ante asymmetric information, assume that at the beginning of the lending period borrowers are not equal and that they have more information about future profitability of their investment projects than banks. Therefore different borrowers have different probabilities of repaying their loans.
Models assuming ex-post asymmetric information between lenders and borrowers deem all borrowers as equal at the beginning of the period. Borrowers and lenders have the same information at the beginning of the period, but there is asymmetrical information on the rate of return on the borrowers investment project. If the bank attempts to monitor the data, then it faces high monitoring costs. Ex-post asymmetric information models assume, that all borrowers have equal probability of misreporting their projects actual return in order to increase their expected utility. The behaviour of the agents in ex-post and ex-ante asymmetrical models is significantly different therefore it is worth analysing both types of model in more detail.
Ex-ante asymmetrical models focus on the informational asymmetries that arise due to moral hazard and adverse selection of the borrowers. Cosci (1992) makes the following underlying assumption for the general model of credit rationing. Since each loan applicant has insider information about the possible outcome of the project it is possible to capture information differences between applicant and banks by riskiness parameter T. The return on the project might be expressed as R(T) and the probability of negative return on the project will be expressed as F(R(T)). Each applicant knows its riskiness parameter T while banks know only the general distribution of the R(T).
Stiglitz and Weiss (1981) show in their model that the interest rate level might directly influence the loan pool financed by the bank. Particularly, it is assumed that that higher interest rate leads to higher probability of default. The higher interest rate might have a twofold effect on the probability of repayment. First of all higher interest rates lead to adverse selection effect, which can be explained as a situation where only less risk-averse borrowers apply for the loan.
Figure 2. Optimal interest rate. Stiglitz and Weiss (1981).
As it follows from Figure 2, there is a discrete number of potential borrowers, each with different T, therefore expected returns of the bank are a non-monotonic function of r. As interest rates growth beyond the optimal r1 rate to r2, only risky investors, that expect high returns and take high risks, apply what results in a discrete fall in the banks expected returns. Cleimentz (1986), notes that borrowers might have an option between taking a regular job and applying for the loan. Since a wage is an increasing function of the borrowers skills and abilities, low interest rates will attract a more diversified pool of borrowers, while high interest rates will discourage skilful individuals to apply for the loan since it will be more beneficial for them to remain in the job market. Therefore banks will be lending money to less able borrowers, which might result in a reduction of their returns.
Secondly higher interest rates might affect the actions of the borrowers, and lead to moral hazards. Cleimentz (1986) describes the adverse incentive effect, which occurs when the success of a project depends on the effort of the borrower. As a result of high interest rates, marginal utility of making additional effort falls, therefore the borrower decreases their effort in order to establish equality between the marginal cost of lending and expected marginal return of effort. Jaffee and Russells (1976) model shows that higher interest rates will induce a larger share of borrowers to default. Since the costs of repayment of a loan increases as interest rates grow, borrowers might be tempted to default on their loan whenever their utility is increased by doing so. Alternatively, an increase in interest rates might induce individuals to undertake risky and more profitable projects. For example at a given interest rater, a risk-neutral firm is indifferent between two projects, an increase in the interest rates results in the firm preferring the project with the high probability of bankruptcy (Stiglitz and Weiss, 1981). This can be seen from Figure 3.
Figure 3 The Return to the Bank is a concave function of the returns on the project. (Stiglitz and Weiss, 1981)
The expected utility (V) of the lender does not depend on the different rates of projects returns, as long as a company can achieve rate of return (R*) which is sufficient to repay a loan. Lenders are highly interested in obtaining as high R as possible therefore firms might respond to an increase in the loan interest rate by choosing projects with higher risk. Therefore the bank faces a moral hazard problem if it is unable to specify all the characteristics of the borrowers investment projects in the loan contract or if it cannot control implementation of the agreement (Cosci, 1992).
The adverse selection aspect of the interest rate arises due to the existence of borrowers who have different probabilities of repaying their loans. Banks may use a variety of screening tools to identify good borrowers. According to Stiglitz and Weisss (1981) model, the interest rate which individuals are willing to pay may be one of the screening tools. When the interest is high, the average riskiness of borrowers increases, since only those who intend to default of and/or undertake high risks projects will apply. Another way to screen the applicants is to impose collateral requirements. Increasing collateral may have a beneficial effect and lead to lower risks of default, but this is not necessarily the case for all borrows. Wette (1983) argues that the collateral requirements might result in a situation where only firms that have risky projects apply for a loan, since the expected utility of the borrowers is an increasing function of the riskiness of the investment projects. For each possible collateral, individuals can identify the appropriate level of risk T, as the bank imposes collateral requirements the critical value of T growth, since borrowers are willing to take more risk to obtain the required rate of return. Stiglitz and Weiss (1981) assumed that riskiness of the banks clients might depend on their current wealth and wealthy individuals are less risk averse; therefore an increase in collateral might attract the particular group of the high wealth risky clients. Nevertheless, Bester(1985) showed that if banks decide on the interest rates and collateral simultaneously rather than separately, obtaining equilibrium without credit rationing becomes feasible. As a concluding remark it is worth stressing that while imposing collateral allows shifting underlying income distribution and is widely used by banks in practice, collateralisation cannot lead to elimination of the credit rationing.
Ex-post asymmetric models are based on the assumption that borrowers and lenders have the same information at the beginning of the period, but information becomes asymmetric after an investment project is completed. Behaviour of the borrowers and banks can be explained in the following way. Both lender and borrower agree on the distribution of expected returns R(T), the realisation of the project does not depend on the actions of the borrower. The level of risk T associated with each project is observed by the bank. The borrower implements projects according to the terms specified in the agreement. However, the moral hazard arises due to ex-post information asymmetries, since the borrower can claim a very low value of the return obtained by the project (Cosci, 1992). Williamson (1987) presents a model in which high monitoring costs and ex-post asymmetric information results in credit rationing. The lender can observe the borrowers project outcome but incurs monitoring costs. Particularly if the borrower reports the failure of the investment project and defaults, the bank has to verify the loss. Williamson (1987) concludes that neither adverse selection nor moral hazards are therefore necessary for rationing to exist.
Wang (2000) stresses that costly bankruptcy alone can cause credit rationing even if information is symmetric between borrowers and lenders. If bankruptcy costs are minimal, i.e. lenders can causelessly confiscate the borrower’s collateral and investment residual upon bankruptcy, credit rationing would not occur. With non-trivial bankruptcy costs, however, the lenders’ profit function is concave throughout the relevant range of interest rates, and there exists an interest ceiling beyond which further raising of the interest rate would decrease profit.
The examination of various models on credit rationing reveals the following types of asymmetry that generate rationing in the credit market:
� adverse selection, since higher required rate of return or collateral attracts riskier borrowers.
� moral hazard encourages firms to choose riskier projects or misreport results of their investment activities.
� monitoring and bankruptcy costs: lead to higher costs and causes rationing.
The main theoretical conclusion of this paper is that: all types of asymmetries mentioned above arise due to market imperfections, therefore results of the analysis suggest that credit rationing would not exist in the perfect market and can be perceived as a result of imperfections in a credit market.
Bester, H. 1985, Screening versus Rationing in Credit Markets with Imperfect Information, American Economic Review, 75(4), September, 850-855
Clemenz, G. 1986 Credit market with Asymmetric Information, Springer, Verlag, London.
Cosci S 1992 Credit rationing and asymmetric information. Dartmouth Publishing, Vermont
Jaffee, D. and Russel, T. 1976 Imperfect information, Uncertainty and Credit Rationing Quarterly Journal of economics.
Stiglitz, J. and A. Weiss, 1981, Credit Rationing in Markets with Imperfect Information, American Economic Review, 71(3), June, 393-410
Wang, Hung-Jen 2000 “Symmetrical Information and Credit Rationing: Graphical Demonstrations,” Financial Analysts Journal, 56 (2), 85-95.
Williamson, S., 1987, Costly Monitoring, Loan Contracts, and Equilibrium Credit Rationing, Quarterly Journal of Economics, Feb, 135-145
Wette, H., 1983, Collateral in Credit Rationing in Markets with Imperfect Information: Note, American Economic Review, 73(3), June, 442-445