Part 4

Question 1

What are the three external factors leading to capital rationing

Answer 1

1. Risk Aversion and Lender Pessimism
2. Interest Rate constraints and market dynamics
3. Information Asymmetry and default risk

Question 2

Factor 1: limited knowledge and over optimism

Answer 2

Catt (1965) explains that lenders often view potential borrowers with skepticism due to their limited knowledge of the industry and perceived over-optimism on the part of borrowers.

Question 3

Factor 1: borrower projections, macroeconomic risks

Answer 3

Lenders also discount borrower projections, factoring in macroeconomic risks that borrowers may overlook

Question 4

Factor 1: supply curve

Answer 4

This results in a supply curve that does not fully accommodate borrowers’ demand for funds, especially when lenders cannot raise interest rates sufficiently to clear the market without increasing default risk

Question 5

Factor 1: sticky interest rates

Answer 5

The concept of sticky interest rates, as discussed by Stiglitz and Weiss (1981), emphasizes that increasing rates too much may deter cautious borrowers and lead to adverse selection.

Question 6

Factor 2: interest rates and sources

Answer 6

According to Wilson Committee (1980) and subsequent studies by Lonie, Power, and Sinclair (1990), raising interest rates to control demand can inadvertently lead to capital rationing.

Question 7

Factor 2: smaller firms impact

Answer 7

Smaller firms are more affected by these external capital constraints due to their limited access to capital markets and high sensitivity to rate increases.

Question 8

Factor 2: short term interest rate spikes impact

Answer 8

For example, short-term interest rate hikes intended to curb inflation may impact corporate financing indirectly by reducing customer demand, which in turn affects company revenues and, thus, internal funding availability.

Question 9

Factor 3: information asymmetry

Answer 9

Information asymmetry—where lenders cannot fully observe the borrower’s intended use of funds or their ability to repay—often results in restricted lending.

Question 10

Factor 3: unsatisfied fringe

Answer 10

This scenario leads to a persistent “unsatisfied fringe” in the market where demand for capital remains unmet.

Question 11

Factor 3: default risks

Answer 11

Lenders, concerned about default risks, are reluctant to extend additional credit, causing firms to face rationing despite the presence of positive NPV projects.

Question 12

what does default risk mean

Answer 12

risk of repayment of investment, risk borrower unable to meet debt obligations

Question 13

what literature is referred to in risk aversion and lender pessimism

Answer 13

Catt 1965 - lenders view borrowers with skepticism due to limited knowledge and perceived optimism from borrowers

Stiglitz and Weiss 1981 - sticky interest rates

Question 14

what literature is referred to in interest rate constraints and market dynamics

Answer 14

Wilson committee 1980
Lonie, Power and Sinclair 1991