Credit rationing by definition is limiting the lenders of the supply of additional credit to borrowers who demand funds at a set quoted rate by the financial institution. It is an example of 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 "too expensive" for some borrowers, that is, situations where the interest rate is deemed too high. With credit rationing, the borrower would like to acquire the funds at the current rates, and the imperfection is the absence of supply from the financial institutions, despite willing borrowers. In other words, at the prevailing market interest rate, demand exceeds supply, but lenders are willing neither to lend enough additional funds to satisfy demand, nor to raise the interest rate they charge borrowers because they are already maximising profits, or are using a cautious approach to continuing to meet their capital reserve requirements.Definitions for the whole article are based on class notes by Anton Korinek, University of Maryland.
Forms Credit rationing is not the same phenomenon as the better-known case of food rationing. Credit rationing is the result of asymmetric information whilst food rationing is a result of direct government action. With credit rationing, lenders limit the risk of asymmetric information about the borrower through a process known as credit assessment. Credit assessment is completed during the loan application process by applying a set criterion to an application which results in either a loan approval or decline. Credit assessment is one way that the lender reduces risk of loan default and is thereby one example of how lenders may apply credit rationing in practice.
These types of credit rationing can usually be distinguished:
The most basic form of credit rationing occurs when the value of collateral provided by the borrowers drops significantly and affects the quality of the lender's capital. Collateral provides assets to the bank meeting the minimum requirements set by regulators and may commonly be used to calculate the LVR (Loan to Value Ratio) of the loan. Plunges in the value of the collateral provided to a financial institution may enhance credit rationing. This is because when the collateral (or security) provided to the lender falls in value, changing the LVR of the loan, the lenders risk of financial loss increases should the borrower default and the financial institution may not be willing to provide further lending. "Redlining" is the situation where some specific group of borrowers, who share an identifiable trait, and pose a higher risk to the lender, cannot obtain credit with a given supply of loanable funds, but could if the supply were increased and the lending assessment criteria were relaxed. More importantly, they would not be able to get loans, even if they were willing to pay higher interest rates due to their affiliation with this group whom the lender deems to be an unsuitable risk. "Pure credit rationing" is the situation in which within an observationally indistinguishable group where some obtain credit while those who are willing to pay a higher interest rate do not. Disequilibrium credit rationing is a temporary feature of the market because of some friction that prevents clearing.
Theoretical background One of the main roles markets play is its allocation of goods; they allocate goods to the buyers with the highest valuation. 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 "too high" by the consumers, supply will exceed demand, and sellers will have to reduce their prices until the market clears (i.e., equilibrium is reached). On the other hand, if prices are "too low", then demand will be higher than supply, and prices will have to be raised to obtain market clearing.
The graph to the right illustrates the loan market at its equilibrium point. This is where, the total saved (notated S) is equal to the total invested (notated I) at a given equilibrium interest rate (notated r*). When there is no shift in either the S or I line, a rise in the interest rate will create surplus for entities looking to save. This is because the interest rate is higher than the provided level out output at that same interest rate. On the other hand, if the interest rate were to decrease there would be surplus for investing entities as the interest rate is lower than required at that output level.
This also intuitively makes sense. As the interest rates rise, entities that save money are more inclined as their marginal utility is rising. As the interest rates decrease, investors are more incline to borrow more as their total cost of borrowing is decreasing. Furthermore, the rise and fall of interest rates is usually controlled by institutions such as the Fed (USA) or the RBA (Australia) in order to stimulate or control inflation within an economy and often works hand in hand with the supply and demand of financial institutional lending which may eventually result in credit rationing and further result in market equilibrium by manipulating excess demand or supply of funds.
This is illustrated, when S=I, the market will be in equilibrium at interest rate r*.
Disequilibrium credit rationing The more mundane case of credit rationing occurs when the credit market is, for one reason or another, out of equilibrium. This could either be due to market shocks, friction in the market, or some government policy (such as anti-usury laws), which prevent supply and demand from being equalised. Disequilibrium outcomes are temporary adjustments and shocks as the economy moves back to the long run equilibrium—the equilibrium that will attain over some indeterminate amount of time in the absence of more external shocks. 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, who first introduced this idea within a supply and demand framework.
The more interesting case, that of equilibrium credit rationing, is the result of structural features of the market (in particular, adverse selection), and will characterise long run market outcomes (barring some technological breakthrough) and is analysed below.
Equilibrium credit rationing – Stiglitz and Weiss
The seminal theoretical contribution to the literature is that of Joseph Stiglitz and Andrew Weiss, who studied credit rationing in a market with imperfect information, in their 1981 paper in the American Economic Review. 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 may not be willing to lend the extra funds, as the higher rate would imply lower expected profits. This may be an example of equilibrium rationing where there exists excess demand for credit at the equilibrium rate of interest. Market equilibrium may be further enhanced, however, by lenders who are in competition with each other, and where one lender may be willing to accept a higher risk than another which may result in a balance of lending to borrowers who may also be willing to accept a higher risk and/or pay a higher rate to borrow. The reason this may lead to an equilibrium may be that lenders policies regarding adverse selection may vary and 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. Additional risk is taken into account by an increase to the cost of borrowing or rather the interest rate paid. Note that when a lender restricts their lending and decides to keep the rates lower, this assumes limited liability, and supports the notion of credit rationing, though results could still hold with unlimited liability.
Pure credit rationing In a framework similar to Stiglitz and Weiss, one can imagine a group of individuals, prospective borrowers, who want to borrow funds in order to finance a project, which yields uncertain returns. 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 $75 to $125, so that the value of type A projects is at least $75 and at most $125, and the expected value (mean) is $100.
Now, assume type B project returns are also uniformly distributed, but their range is from $50 to $150. Type B project returns also have an expected value of $100 but are more risky.
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 may, amongst other tools, use the interest rate.
This was the main intuitive observation of Stiglitz and Weiss. They realised that an individual who is willing to accept a higher interest rate with their loan is doing so because they know that the riskiness of their 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 they know 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.Note that the assumption is that the riskier project could lead to higher return than the safe project. The case where a project is more varied on a lower range (for example, uniform from $10 to $90, compared to $75 to $125) is theoretically uninteresting, as no profit maximising borrower (with conventionally risk averse preferences, or even mild preference for risk) would ever consider it. The safe borrowers have a high probability of repaying their loan, so even a modest interest rate, relative to their expected return, is likely to result in an unprofitable contract. It is due to these borrower adverse selection risks that banks may utilise credit rationing when approving lending, which is mostly to reduce their own risk of loss.