Credit rationing
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.
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.
The most important contribution in this vein was by Dwight Jaffee and Franco Modigliani,[6] who first introduced this idea within a supply and demand framework.
The seminal theoretical contribution to the literature is that of Joseph Stiglitz and Andrew Weiss,[4] 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.
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.
[note 1] 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.
What this implies for the banks is that there will be a range of relatively low interest rates below which all the applicants will accept the loan, and a cut-off point above which the safe borrowers decide to drop, as expected repayment becomes too high.
Naturally, there exists a (higher) cut off point for the risky types as well, above which even they would not be willing to borrow and assists in maintaining market equilibrium.
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.
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.
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.
Redlining can have long-lasting effects on credit access for affected communities, leading to reduced economic opportunities and perpetuating a cycle of poverty.
To address the negative effects of redlining and promote equal access to credit, policymakers may implement measures such as anti-discrimination laws, affirmative lending programs, or community reinvestment requirements for financial institutions.
It was one of a series of papers to address the important phenomenon of adverse selection in economics, pioneered by the classic study of the lemon problem in used car markets by George Akerlof,[7] and celebrated by the paper by Michael Rothschild and Stiglitz on adverse selection in the insurance market.
According to Eatwell, J. Malgate, M. Newman, P. (1989) credit rationing was briefly discussed in the context of usury ceilings by Adam Smith (1776), was a hot topic for debate in 19th Century England in regards to the bullion and currency controversies and also became topical in the USA following World War II as part of the ‘availability doctrine’ first developed by Roosa (1951) and others in the Federal Reserve System.
[9] However, the first paper to treat credit rationing as a possible equilibrium phenomenon caused by adverse selection was by Dwight Jaffee and Thomas Russell in 1976.
This prompted a sister paper by the same authors,[12] where they show that, on the one hand, credit rationing can occur even under symmetric information, and, on the other, that it might not imply a market failure.
The twist in this model, compared to the cases described above, is that entrepreneurs can influence the outcome of the investment, by exerting high or low effort.
Competition between lenders and high effort by borrowers ensure positive outcomes for the economy and society, so investment should take place.
In the short term this may result in higher agency cost and lower initial assets for the financial institution which may therefore lead to short-term credit rationing.
With rising house prices, and, more importantly, with the expectation of future rises in housing price, the expected return on the project to be financed was perceived to be higher than suggested by fundamentals, leading, on the one hand, to ever lower required X by banks in order to make loans, and, on the other, to inflated estimates of the value of the borrowers' initial assets.
This led to less credit rationing, to the extent that good investments that should be undertaken got their financing, but also to subprime lending, where bad loans to poor projects were made.
Some experts believe that the threat of the country being shut off from financial markets if it defaults is not credible, as it has to be the case that absolutely no-one is willing to lend.
[14] Others stress that though this might be true for the short term, there are other reputational reasons why a country might want to avoid debt repudiation, mainly pertaining to the maintenance of good foreign relations, which allows access to international trade and technological innovations.
The seminal contribution is by Jonathan Eaton and Mark Gersovitz,[16] who consider a simple model of international lending for a small open economy.
Lenders set a maximum amount they are willing to lend (credit ceiling), which might be smaller or larger than the borrowing needs of the country.
Drawing on the famous Oxford surveys of businessmen in the 1930s he argued that it was likely that changes in the interest rate did not have a substantial effect on investment decisions.
Harrod went on to argue that the main channel through which interest rates curtailed economic activity was through the process of what is now known as credit rationing.
This can have negative consequences for borrowers, such as limiting their ability to invest or start a business, and for the economy as a whole, as it can lead to decreased economic growth and productivity.
