Credit rationing

The efficiency of financial markets has long been disputed. One of the earliest and most thoroughly analysed cases of inefficiency of these markets is a phenomenon called "credit rationing": lenders (typically commercial banks) refrain from supplying credit to borrow- ers (typically investing companies or dissaving, consuming households) despite the fact that these borrowers are willing to pay a higher interest rate. Therefore, credit rationing refers to a situation of "market failure", as the market equilibrating mechanism of price adjustment is not working. If such behaviour becomes paramount, "Keynesian" proper- ties of lasting unemployment and persistent output gaps become plausible at the macro- economic level. Hence, credit rationing is part of the toolbox of Neo-Keynesianism (see for instance Greenwald and Stiglitz, 1993).

Figure Credit rationing

Commonly, Stiglitz and Weiss (1981) are referred to as the pioneers of "credit rationing". Although they certainly authored the seminal paper with regard to the microeconomic foundations of credit rationing behaviour of rationally acting banks, there had been an extensive literature on the phenomenon as early as the 1960s (see for instance Hodgman, 1960; Freimer and Gordon, 1965; Jaffee and Modigliani, 1969). The theory of credit rationing can be illustrated as follows (see Figure). We assume ordinary credit demand \( (Cr^{d})\) and credit supply \( (Cr^{s})\) curves. Ceteris paribus, borrowers demand more credit with a falling interest rate (i) and lenders offer more credit with a rising interest rate. Additionally, we assume that credit default risk is increasing with rising interest rates as the portfolio will be pushed towards riskier borrowers (adverse selection effect) and borrowers may get an incentive to engage in riskier projects (moral hazard effect).

Rational bankers will increase credit supply until interest earnings will be overcom- pensated by the (expected) cost of credit default: bank's profits (Q) will be at maximum at point A. As the credit supply curve with increasing default risk \(Cr^{s}_{2}\)  is lower than the (notional) credit supply curve with constant default risk \(Cr^{s}_{1}\) , equilibrium interest    rate i* and equilibrium loan size \(Cr^{e}\)  are higher than interest rate \(i_{1}\) and \(Cr^{r}\) turn out in a situation of credit rationing. This is commonly also called an "equilibrium outcome", as it reflects rational behaviour. However, both the adverse selection and the moral hazard effects only occur when one side of the credit market (the borrowers) has more and better information than the other side (the lenders); that is, on the assumption of imperfect, asymmetric information.

Credit rationing has come under theoretical and empirical critique. As it is based on increasing credit default costs owing to adverse selection and moral hazard effects under asymmetric information, arrangements to neutralize credit default costs, such as collater- als, or to mitigate asymmetric information problems by the use of self-selection mecha- nisms, such as different types of loan contracts, have been put forward to re-establish the market clearing solution of unconstrained loan markets even under imperfect infor- mation (see for instance Wette, 1983; Bester, 1985). Empirically, it has been shown that interest-rate stickiness, which is a common feature of credit markets, is a necessary but non-sufficient condition for the proof of credit rationing. Berger and Udell (1992) point out that much of existing interest-rate stickiness is better attributed to implicit interest- rate insurance arrangements than to credit rationing, which they argue to be a rather insignificant macroeconomic phenomenon.

Finally, in the heterodox literature, a post-Keynesian version of the theory of credit rationing has been put forward (see Wolfson, 1996), which does not rest on asym- metric information as its Neo-Keynesian counterpart but on asymmetric expectations. Assuming fundamental uncertainty and the non-existence of objective or subjective probability functions - that is, non-ergodicity as one of the crucial axioms of post- Keynesianism - credit rationing behaviour of banks (and other financial intermediaries) can easily be made plausible once we allow for a different evaluation of the economically relevant future, to wit, if we assume that lenders and borrowers systematically differ in their expectations in a way that borrowers are typically more confident in the economic future of their project than a potential lender. Note that this outcome is independent of the distribution of available information and the risk preference of borrowers and lenders. It has been shown that credit rationing based on expectations and states of con- fidence can easily be integrated into a Minsky-type process of financial instability (see Alves et al., 2008, pp. 413ff) and, thus, gain macroeconomic significance particularly for the business cycle.

See also:

Asymmetric information; Collateral; Efficient markets theory; Financial instability; Output gap.