Credit Rationing

Question 1

What is Stinglitz and Weiss starting point ?

Answer 1

Credit often rationed = excess demand for loans

→ Some borrowers cannot obtain loan despite willingness to pay higher interest rates

Question 2

What are the key questions of credit rationing ?

Answer 2

• Why are credit markets especially prone to rationing ?

* Why do banks not simply increase interest rate they charge until supply = demand ?

Question 3

What are the reasons for credit rationing ?

Answer 3

• Caps on interest rates
• Bans on price discrimination
• Restricted access to credit markets

Question 4

What is Stiglitz and Weiss basic idea ?

Answer 4

Asymmetric information plays crucial role in credit markets :

• Lenders typically do not participate in management of projects they finance

→ Lenders only have limited knowledge about borrowers’ projects and actions

→ Changes in interest rate not only affect loans’ quantity but also quality

→ Average loan quality deteriorates if interest rate raises :
o Moral Hazard : borrowers tend to choose riskier projects
o Adverse selection: “Good” borrowers stop applying

→ Lenders may set interest rate below market clearing level as they use it as incentive mechanism and screening device

Question 5

What is the model’s structure ?

Answer 5

Large number of borrowers, each of them looking for loan B to finance project:

• Projects yield same expected return but differ in risk θ
• Higher θ = riskier project = project with more volatile return distribution
• Project’s realized return R ≥ 0 observable ex-post
• Risk θ = private information to the borrower

Question 6

What is the bank’s loan contract ?

Answer 6

• Each borrower needs to put down collateral C upfront in order to borrow B at interest rate r
• Banks cannot observe projects’ risk θ → all borrowers face same interest rate r
• By assumption all borrowers provide same collateral C
• Limited liability : if collateral and project’s return are insufficient to pay back loan with interests, i.e. C + R ≤ (1+r)B → borrower defaults + faces no obligations except that collateral and project’s return go to the bank

Question 7

What are the borrower’s return profile ?

Answer 7

• π(R,r)=max⁡[R-(1+r)B,-C] where returns R are stochastic and follow the density f(θ)

• Equals one of holding call option :
o Full upward risk
o Limited downward risk (Limited liability)

Question 8

What are the bank’s return profile ?

Answer 8

• ρ(R,r)=min⁡[B(1+r),R+C] where returns R are stochastic and follow the density f(θ)

• Equals the one of selling a put option
o Limited upward risk
o Full downward risk

Question 9

What happens if there is an increase in risk ?

Answer 9

• Extreme returns get more likely
• Borrower benefits from increased upward risk
• Bank bears higher downward risk

→ Borrower’s position improves at the bank’s expense

→ Option value increases

Question 10

What are the implications of an increase in risk ?

Answer 10

• Moral hazard (ex-post) : Borrowers have incentive to take higher risks
• Adverse selection (ex-ante): Borrowing more attractive for risky borrowers

Question 11

What happens if there is an increase in interest rates ?

Answer 11

• Aggravates moral hazard and adverse selection

* Average loan quality deteriorates

Question 12

What are the two contrarian effects for banks to charge higher interest rates ?

Answer 12

• Higher interest rates = increase of returns

* Aggravates moral hazard and adverse selection → impair average loan quality

Question 13

What are the main results of Stiglitz and Weiss ?

Answer 13

• Asymmetric information may lead to credit rationing in equilibrium
• Reason: interest rate increases compromise avg credit quality by aggravating adverse selection and/or moral hazard
• May be optimal for banks to charge interest rates below mkt clearing lvl

Question 14

What do lenders also use as collateral requirements to mitigate the effects from moral hazard and adverse selection ?

Answer 14

• Incentive mechanism

* Screening device

Question 15

What is the incentive mechanism for a borrower ?

Answer 15

Higher collateral requirements help to align the lenders’ and borrowers’ interests:

• If borrowers have to put down more collateral incentive for choosing risky project lower

→ Borrowers can offer higher interest rates without getting suspicious of taking excessive risks

→ Credit rationing can be avoided if banks’ return function ρ(r) upward sloping in relevant interest rate area

Question 16

What is the incentive mechanism for a bank ?

Answer 16

Higher capital requirements lower banks incentives to take excessive risks at expense of depositors, deposit insurance and/or tax payer.

Question 17

What do higher requirements impact on a graph ?

Answer 17

• Point (1+r)B – C shifts left as C → C’
• Borrower’s stake is higher
• Borrower bears more downside risk
• Bank faces less downside risk

→ Borrower’s incentive to take excessive risk is lower

→ Less moral hazard

→ Less adverse selection

Question 18

What are the main ideas of the screening device ?

Answer 18

• Borrowers select one of various debt contracts that differ in collateral requirements and interest rates
• Low risk borrowers are willing to provide more collateral (equity) to get lower interest rate
• Borrowers may self-select into different debt contracts