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American Economic Association

Credit Rationing in Markets with Imperfect InformationAuthor(s): Joseph E. Stiglitz and Andrew WeissSource:

The American Economic Review,

Vol. 71, No. 3 (Jun., 1981), pp. 393-410Published by: American Economic AssociationStable URL:

http://www.jstor.org/stable/1802787

Accessed: 05/06/2009 11:02

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CreditRationinginMarketswithImperfectInformation

ByJOSEPH E. STIGLITZAND ANDREW WEISS*

Why iscredit rationed?Perhaps themostbasic tenetof economicsis that market equi-librium entailssupply equallingdemand;thatif demand shouldexceedsupply, priceswillrise, decreasingdemandand/orincreasingsupplyuntil demandand supply areequatedat thenewequilibriumprice.So if pricesdotheir job,rationingshould not exist.How-ever,credit rationingand unemploymentdoin fact exist.They seemto imply anexcessdemandforloanable fundsor an excesssupplyof workers.One methodof"explaining"thesecondi-tionsassociates themwith short-or long-termdisequilibrium.In the short term theyareviewedas temporarydisequilibriumphenom-ena; thatis, theeconomyhas incurredanexogenousshock,andfor reasons not fullyexplained,thereis some stickinessintheprices oflabor or capital(wages andinterestrates)so that thereisatransitionalperiodduringwhichrationingofjobsor creditoc-curs.Ontheotherhand,long-termun-employment(abovesome "natural rate")orcredit rationingisexplainedby governmen-talconstraints suchasusurylaws ormini-mumwagelegislation.'The objectof this paper isto show thatinequilibriuma loanmarket maybe char-acterized bycredit rationing.Banks makingloansare concerned aboutthe interestratethey receiveon the loan, and the riskinessoftheloan.However,theinterest ratea bankchargesmay itselfaffect theriskiness of thepool ofloans by either: 1) sortingpotentialborrowers (theadverse selection effect);or2)affectingthe actions of borrowers (theincen-tive effect).Both effects derive directly fromtheresidual imperfectinformationwhich ispresentin loan markets after bankshaveevaluatedloan applications. Whenthe price(interest rate) affects thenature of the trans-action,itmay notalso clear the market.The adverse selectionaspectofinterestrates is a consequenceof differentborrowershaving differentprobabilities ofrepayingtheirloan.Theexpectedreturn to the bankobviouslydepends onthe probabilityof re-payment,so the bank wouldliketobe ableto identifyborrowers who are more likely torepay. It is difficult toidentify "good bor-rowers,"and to do so requires thebank touseavarietyofscreeningdevices.Theinter-estratewhich an individualis willing to paymayact as one such screeningdevice: thosewho arewilling to pay high interestratesmay,onaverage,be worse risks; theyarewilling toborrow at high interestrates be-cause they perceivetheirprobabilityofre-paying theloantobe low.Asthe interestrate rises, the average"riskiness" of thosewho borrow increases,possibly lowering thebank'sprofits.Similarly,as the interest rateand otherterms of the contract change,thebehavior ofthe borrowerislikely to change.Forin-stance,raising theinterest rate decreasesthereturnon projectswhich succeed.Wewillshowthat higher interestratesinduce firmsto undertakeprojectswithlowerprobabili-tiesofsuccess buthigher payoffswhen suc-cessful.In aworld with perfectand costlessinfor-mation,thebank wouldstipulatepreciselyalltheactionswhichtheborrowercould

*Bell Telephone Laboratories, Inc. and PrincetonUniversity, andBellLaboratories, Inc., respectively.Wewould like to thank Bruce Greenwald, Henry Landau,Rob Porter, and Andy Postlewaite for fruitful commentsand suggestions. Financial supportfrom the NationalScienceFoundation isgratefully acknowledged.Anearlier version of thispaperwaspresentedat thespring1977 meetings of the Mathematicsinthe Social SciencesBoardinSquam Lake, New Hampshire.'Indeed,even if markets were not competitive onewould not expect to find rationing; profit maximizationwould, for instance, lead a monopolistic bank to raisethe interest rate itchargeson loans to thepointwhereexcess demand for loans was eliminated.393

394THEAMERICANECONOMICREVIEWJUNE1981

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INTERESTRATEFIGURE1.THERE EXISTSANINTERESTRATEWHICHMAXIMIZESTHEEXPECTEDRETURN TO THEBANK

undertake which mightaffect thereturntotheloan). However,the bank isnot able todirectly controlall theactions of the bor-rower; therefore,t willformulate he termsoftheloan contractna mannerdesignedoinducethe borrower to take actions whichareinthe interestofthebank,aswell as toattractow-riskborrowers.For boththesereasons, the expectedre-turnbythe bankmayincreaselessrapidlythantheinterestrate; and, beyondapoint,may actuallydecrease,asdepictednFigure1.The interest rate atwhich theexpectedreturn othebankismaximized,we refer toas the"bank-optimal"ate, Pr.Both the demandforloans and thesupplyof fundsare functions of theinterest rate(thelatterbeingdeterminedbytheexpected

return at r*). Clearly,it isconceivable that at

rthedemand for funds exceeds thesupplyoffunds.Traditionalanalysiswouldarguethat, inthepresenceof anexcess demand orloans,unsatisfied borrowerswouldoffertopayahigherinterest rateto thebank,bid-ding upthe interestrate untildemandequalssupply.Butalthough supplydoes notequaldemand atr*,itistheequilibriumnterestrate! Thebankwould notlendtoanindivid-ual whoofferedtopaymorethanr*.Inthebank'sudgment,such a loanislikelyto be aworseriskthan theaverageoanatinterest

rateP*,and theexpectedreturn to aloan at

an interest rateabover*isactuallylowerthantheexpected return to the loans thebankis presently making. Hence, there areno competitiveorces eadingsupply to equaldemand, and credit s rationed.But the interestrate is not the only term ofthe contractwhichsimportant.Theamountof the loan, and the amount of collateral orequity the bank demandsof loanapplicants,will also affectboth the behavior of bor-rowers andthedistributionofborrowers.InSection III,weshow thatincreasingthecol-lateral requirementsf lendersbeyond somepoint) maydecrease hereturnsto thebank,byeitherdecreasingtheaverage degree ofriskaversionofthe poolofborrowers;or inamultiperiodmodel inducingindividual in-vestors toundertake iskierprojects.Consequently, t may not be profitable toraisethe interestrateorcollateral require-ments when abank has an excess demandforcredit;instead,banksdenyloans to bor-rowerswho are observationally indis-tinguishable romthose who receive loans.2It is not our argument hat credit rationingwill alwayscharacterize apital markets, butrather that it may occur under not implausi-bleassumptions concerning borrower andlender behavior.Thispaperthusprovidesthe firsttheoret-ical justificationoftruecreditrationing.Pre-vious studies havesoughttoexplain whyeach individualfacesanupward slopingin-terestrateschedule.Theexplanationsofferedare(a)theprobabilityof defaultforanyparticularborrowerncreasesasthe amountborrowedincreases(see Stiglitz 1970, 1972;Marshall FreimerandMyron Gordon;Dwight Jaffee;George Stigler),or(b)themix of borrowerschanges adversely (seeJaffee and ThomasRussell).In these circum-stances we wouldnotexpectloans of differ-entsizetopaythe same interestrate, anymorethan wewouldexpecttwoborrowers,one of whom has areputationorprudenceandthe other areputationas a badcreditrisk, to be abletoborrowatthe same interestrate.Wereserve theterm creditrationingforcircumstancesn whicheithera) amongloanapplicantswhoappearto be identical some