Why Do Banks Ration Credit?
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This essay is about credit rationing. The first part of the essay introduces you to the reasons and purposes why banks ration credit. Included in the first part are the roles of adverse selection and moral hazards in determining the lending policy of particular banks. The essay further expands the topic as it includes other subtopics relating to the main topic of credit rationing. These are the three paradigms of credit rationing namely price rationing, disequilibrium quantity rationing, and equilibrium quantity rationing. Discussions on the said topics are also included as it approaches the end of the paper.
It is argued that most of the early banks’ lending decisions were politically motivated and skewed, with preference to the rich merchants. Overly stringent laws, usually championed by the agrarian critics themselves, forced bankers into that lending pattern. Many bank charters in the early periods forbade banks in raising additional equity capital or increasing interest rates above a low ceiling or usury cap. When market interest rates exceeds beyond the usury cap, as they usually were, banks were naturally flooded with discount applications. Due to these prohibitions by law, banks were forced into credit rationing. This is the natural act of banks in lending only to the safest borrowers. These are characterized as the most known persons/institutions to the bank and those with the highest wealth levels.
Before a lender knows, whether it is safe or not to lend this person, he must first screen the potential borrowers. In addition, monitoring the behavior of the borrower is also needed, even after the loan is made. For the first issue, the lender needs to choose borrowers of high credit quality before granting a loan in order to minimize losses on his part due to default. This is if asymmetric information makes it impossible to distinguish good and bad risks. This is termed as the problem of adverse selection. If the lender was unable to distinguish the bad risks, he will charge an average interest rate (between good and bad). Therefore, high quality borrowers (HQB) pay more than they should, while the low quality borrowers (LQB) less. Due to his situation, some of the HQB drops out of the market, worsening the mix. Higher interest rates even make the problem worse, and even worse as LQB (with low probability of repayment) are willing to pay the said rates. An answer to this problem is the suitable collaterals, as it provides compensation even if the borrower turns out to be of low quality, and defaults.
For the second issue, it is done to ensure that the borrower will not do anything that is against the lender’s interests, while the loan is still outstanding. One specific situation to show this is the problem of moral hazard. In here, the borrower might use the funds in engaging into high-risk activities, which can lead to a low possibility of loan repayment. Moral hazards (and expenditures incurred to overcome it) are a form of agency costs, like costs arising from the separation of principal (lender) and agent (borrower). It is due from the inconsistent incentives arising in a contract, specifying a fixed value payment between debtor and creditor, particularly given limited liability. The debtor prefers the course of action that maximizes his wealth, while the creditor prefers those that maximizes the expected value of his obligation from the debtor. Thus, it creates conflict of interest between the two. There are four ways to reduce this problem and they are reputation, net worth/assets, control and commitment.
A credit’s availability to individual borrowers is limited. The aspects of the debt contract, along with the borrower’s nature, are reflected on the way this availability is being rationed. Financial institutions or direct lenders may respond to credit demands in various ways. The three paradigms of credit rationing are price rationing, disequilibrium quantity rationing, and equilibrium quantity rationing. For the first type, the risk of default is compensated by spreading the interest rate charged on a loan, over a risk-free rate. The second type is the outcome of the government’s direct controls on credit, or slow adjustment of rates to credit’s supply and demand. On the other hand, the last type comes from the severe asymmetries of information between the borrowers and lenders.
In the price rationing of credit, it is implied the fact that “the loans’ interest rate is set for the credit’s supply and demand to equilibrate, through the use of instruments like collaterals to offer lenders further protection,” is not ruled out. Generally, the paradigm assumes away many of the information problems outlined above. Therefore, this makes it applicable only to a subset of cases.
Debt must be held by another agent as an asset. As suggested by the portfolio theory, return demanded by that agent will depend on the risk and on the asset’s expected return. For example, an unsecured consumer loan will command a higher interest rate than a Treasury bill of the same maturity, owing to its relative characteristics of risk. A consumer may default both the interest and the principal, while the government can keep its promises, by the use of its power on tax and to print money. These considerations may be formalized into a theory of the interest rates’ structure. The ‘credit quality’ spread between the yield on a private issue of debt and risk-free debt in the same national market depends on seven factors. These are default risk and associated costs to the lender; the call risk of the bonds’ (or loans’) possibility of early liquidation, at the lender’s probable inconvenient time; status of tax exemption; maturity term/period; any screening or monitoring costs; security or collateral; and market liquidity.
The possibility of the non-collection of interest and principal as promised in the debt contract is called the default risk. This is an apparent difficulty of unsecured loans. However, as noted, returns may be also difficult to obtain even if a loan is collateralized. There is the possibility that the lender will demand a higher expected return, to compensate for the extra risk. An indicator of the market’s assessment of default risk for fixed-rate debt is the differential between the yield on a private bond and public bond. They should be of the same maturity, callability, tax features, etc. It is also important to make a distinction between the three return concepts: the interest rate (coupon), expected return, and the yield.
Relating the price-rationing paradigm to the economics of debt, price-rationing presupposes, either that there is the lack of information asymmetries or there is the possibility of overcoming the problems relating to adverse selection and moral hazard, whether by means of adequate screening and monitoring, reputation, net worth, control, or commitment.
Disequilibrium Quantity Rationing
There are some cases, wherein the normal market equilibrium of the equal supply and demand at a market-clearing price, may not operate. There may be rationing of credit at a non-market-clearing price with excess demand (or supply) of loanable funds, in the sense that among loan applicants who appear to be identical, some receive a loan while others do not.
Credit rationing is characterized by most authors as a disequilibrium phenomenon, as a consequence of the imposed government regulations on credit markets. The typical aim of such regulations lies on enabling the exertion of monetary control without a raise on interest rates, and/or the improvement of credit allocation to preferred sectors. Credit rationing clearly arises in the case of interest-rate controls and with sectoral direction of credit. It is also suggested that government controls on the banks’ balance-sheet growth can lead to credit rationing. Although it depends on whether the banks choose to set a high market-clearing interest rate (there is no rationing for this case), or, they keep lower rates and ration credit, maybe in avoidance to political difficulties.
Behavior endogenous to the market could also result in the form of disequilibrium rationing. It can also arise from the banks’ desire to share interest-rate risks with customers. Alternatively, banks might wish to charge a standardized rate, to ensure fair treatment between broad classes of heterogeneous borrowers. It will fully accommodate the demand of the most preferred borrowers in each class, while rationing credit to the least preferred members. Finally, controlled interest rates may help lessen the borrowers’ search costs. Occasionally, publicly announced changes reassure uninformed borrowers that well-informed banks are not taking advantage of their relative ignorance.
Equilibrium Quantity Rationing
Credit rationing can still arise in equilibrium instances. Therefore, rationing is not necessarily a consequence of market disequilibrium resulting from sticky prices or government regulation, though it is pretty obvious to lead in rationing. An equilibrium rationing is a probable result when the problems of the debt contract set out in the previous parts, apply particularly strongly, i.e. there is imperfect and asymmetric information, and there are incomplete contracts.
As stated in the previous sections, the key is that the interest rate offered to borrowers has affected the risks of the loans in two main ways. First, borrowers who are willing to pay high interest rates may, on average, be worse risks. They may be willing to borrow at high rates, due to the possibility that what they will repay is lower than the average. This is known as the problem of adverse selection. Second, as the interest rate increases, borrowers who were previously in ‘good risks’ may undertake projects characterized by lower probabilities of success, but higher returns when successful. This is the problem of moral hazards, where the incentives of higher interest rates lead to the borrowers’ undertaking of riskier actions.
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