Credit Rationing Flashcards

1
Q

What is Stinglitz and Weiss starting point ?

A

Credit often rationed = excess demand for loans

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What are the key questions of credit rationing ?

A
  • Why are credit markets especially prone to rationing ?

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What are the reasons for credit rationing ?

A
  • Caps on interest rates
  • Bans on price discrimination
  • Restricted access to credit markets
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What is Stiglitz and Weiss basic idea ?

A

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What is the model’s structure ?

A

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
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

What is the bank’s loan contract ?

A
  • 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
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What are the borrower’s return profile ?

A

• 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)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

What are the bank’s return profile ?

A

• 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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What happens if there is an increase in risk ?

A
  • 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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

What are the implications of an increase in risk ?

A
  • Moral hazard (ex-post) : Borrowers have incentive to take higher risks
  • Adverse selection (ex-ante): Borrowing more attractive for risky borrowers
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What happens if there is an increase in interest rates ?

A
  • Aggravates moral hazard and adverse selection

* Average loan quality deteriorates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

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

A
  • Higher interest rates = increase of returns

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What are the main results of Stiglitz and Weiss ?

A
  • 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
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

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

A
  • Incentive mechanism

* Screening device

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What is the incentive mechanism for a borrower ?

A

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What is the incentive mechanism for a bank ?

A

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

17
Q

What do higher requirements impact on a graph ?

A
  • 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

18
Q

What are the main ideas of the screening device ?

A
  • 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