Modern Banking - Credit rationing

What is credit rationing and why does it occur?

occurs when lenders limit the supply of additional credit to borrowers, even if they are creditworthy, due to asymmetric information leading to market failure, adverse selection, and moral hazard.

How does asymmetric information contribute to credit rationing?

contributes to credit rationing because banks cannot perfectly identify risky borrowers, leading to a situation where not all willing borrowers receive loans, despite their creditworthiness.

What is the primary reason borrowers want to borrow money?

Borrowers want to borrow money to invest in projects using collateral.

How do borrowers differ in their risk levels?

Borrowers expect the same average return (R), but they have different risk levels (θ), with riskier borrowers having more uncertain outcomes.

What role does the interest rate (r) play for banks?

The interest rate (r) serves as a screening device to adjust to conditions and filter out riskier borrowers.

What happens when a borrower defaults?

A borrower defaults if the sum of their collateral and project return is less than what they owe.

Why might some borrowers choose not to take a loan?

Some borrowers may choose not to borrow if the loan is too expensive due to a high interest rate (r).

What is adverse selection in the context of banking?

Adverse selection occurs when banks raise interest rates to filter out risky borrowers, but instead attract more high-risk borrowers.

What is the trade-off banks face when setting interest rates?

setting interest rates (r) that balance risk and return.

what is the optimal r with many borrowers?

there is a point (peak of the curve) where increasing interest rates further reduces expected bank return = optimal policy rate

What is credit rationing?

occurs when not all creditworthy borrowers receive loans and safe borrowers leave (high risk stays), leading to excess demand at the optimal interest rate.

What is moral hazard in the context of borrowing?

arises when borrowers choose riskier projects knowing that lenders cannot see their choices, leading to potential losses for lenders.

How does the threshold interest rate (r*) affect borrower project choices?

-              If interest rate < r* → borrower picks safe project A

-              If interest rate > r* → borrower switches to riskier project B

-              Banks want to keep r ≤ r* to avoid borrowers choosing risky projects

how to avoid adverse selection?

• disclosure of information → some may try cheat the system and expensive (free riders)

• collateral and net worth → borrower loose something too but unfair barriers

What is the principal-agent problem?

when the interests of the person giving money (principal) and the person usint it (agent) do not match

What is the principal-agent problem in equity financing?

occurs when managers (run the company) do not act in the best interest of shareholders (own the company), leading to conflicts of interest.

What are some solutions to the principal-agent problem?

-             information about management quality

-              Requiring that managers own part of the project or get stock options, so they share in the gains or losses.

-              Japanese keiretsu groups solve this by having banks own shares in firms, which aligns their interests

-              Threat of takeovers also keeps managers in check.

What is debt financing and how does limited liability affect borrower behavior?

allows borrowers to take risks because of limited liability; they keep profits if a project succeeds but only lose what they owe if it fails. This can lead to credit rationing where lenders become cautious.

What are restrictive covenants in loan contracts?

conditions in loan or bond contracts that limit risky behavior, such as requiring a homeowner to purchase fire insurance to protect the lender's investment.

How do strong financial systems contribute to economic growth?

systems facilitate investment and credit access. Financial intermediaries, like banks, help collect and verify information about borrowers, reducing costs associated with financing.

What are the two main types of financing available to firms?

• direct financing (stock or bonds)

• indirect financing (bank loans)

• but often use own profit (internal funds) → costly but avoid the challenges of raising money

Why do most firms prefer internal financing?

due to information problems, as external funding sources can be expensive and difficult to access due to trust issues. Managers have better knowledge of their firms, making internal funds a safer choice.

What is the limitation of relying solely on internal financing?

• avoids the costs of external funding

• limited and may hinder a firm's ability to grow quickly or seize new opportunities

• necessitating a balance with external financing

• by reducing information frictions