Credit rationing

Credit rationing

The concept ineconomics andbanking of credit rationing describes the situation when a bank limits thesupply of loans, although it has enough funds to loan out, and the supply of loans has not yet equalled thedemand of prospective borrowers. Changing the price of the loans (interest rate) does not equilibrate the demand and supply of the loans. The bank finds that raising the interest rate beyond a certain level actually reduces its profitability.

Joseph E. Stiglitz and Andrew Weiss's 1981 paper was one of the early papers to explain why the bank (or any lending institution for that matter) may credit ration its borrower if 1) the bank was unable perfectly distinguish the risky borrowers from the safe ones 2) the loan contracts were subject to limited liability (if projects returns were less than the debt obligation, the borrower bears no responsibility to pay out her pocket).

Raising the interest rate may causeadverse selection which would lead to an increases the number of 'risky' borrowers in the pool of aspiring borrowers. With higher debt obligations (due to higher interest rate) only the risky borrowers with higher returns would be ready to take up the banks contract. Recall, that with limited liability, the borrowers repay the loan if successful, but escape the consequence of failure of the project. Thus, only borrowers with riskier projects would be ready to take high interest rate loans. Thus, raising the interest rate increases the proportion of the risky borrowers in the project and reduces the overall profitability of the bank.