ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and...

28

Transcript of ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and...

Page 1: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss
Page 2: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE

STIGLITZ AND WEISS MODEL

SANTONU BASU

SCHOOL OF ECONOMIC AND FINANCIAL STUDIES

MACQUARIE UNIVERSITY

1992

Page 3: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

1

Abstract

The credit rationing literature that followed on from the asymmetric

information constraint relies on two central tenets. One is referred to in the case when

borrowers borrow with the preconceived notion that their probability to repay their

loans is low and is known as the adverse selection effect. The other is based on the

presumption that higher interest rates induce firms to switch from lower risk projects

to higher risk projects, and is referred to as the incentive effect. They are described as

mutually exclusive. It is argued in this paper that they are not mutually exclusive and

either of these cases is likely to occur in a large scale, leading to the conclusion that

this literature can at best provide an explanation for the special case of credit rationing

only.

Page 4: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

2

Asymmetric information, credit rationing and the

Stiqlitz-Weiss Model

By Santonu Basu∗

In the last decade Stiglitz and Weiss (1981) in their classic paper titled "Credit

Rationing in Markets with Imperfect Information" provided a theoretical explanation

why bankers ration credit. They argue that the interest rate that banks charge may

itself affect the quality of loans, and therefore that the interest rate alone may not be

capable of clearing the market. This conclusion they derive from two key effects,

namely the adverse selection and incentive effects, both of which were based on the

assumption that banks can sort borrowers according to the expected return on their

investments but not according to the risk.

Since their publication, a number of authors [DeMezza and Webb (1987), Bester

(1985), Besanko and Thakor (1987) and Riley (1987)] have investigated the above

subject matter within the framework of the asymmetric information constraint. Their

findings are either contrary to, or claim less than, those of Stiglitz and Weiss. For

example, De Mezza and Webb (1987) find that the presence of asymmetric

information may lead to either an overestimation or an underestimation of risk,

thereby leading to the possibility of an over or under allocation of credit. These

findings are based on the assumption that banks cannot

∗ I would like to thank D. Collins for his helpful comments and suggestions. I alone

am responsible for the final product.

Page 5: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

3

distinguish among projects that can be ranked according to first order stochastic

dominance. Bester (1985) assumes that banks decide upon the rate of interest and the

collateral of their credit offers simultaneously, rather than separately, and concludes

that in equilibrium no-one will be denied credit. On the other hand, Riley finds that

even if credit rationing occurs due to the adverse selection effect, in each risk pool,

"only in a single marginal pool could rationing ever be observed" (1987, p.224). A

similar conclusion is derived by Besanko and Thakor (1987) who tested the model

with respect to two types of market structures and found that at best the model can

capture a rationing market which is less than the observed level.

A contradictory result might have resulted from changes in assumptions. However the

paramount question remains that even if the rationing occurs due to the presence of

asymmetric information, why do we observe rationing which is less than that which

occurs in the real world?

It will be argued in this paper that Stiglitz and Weiss address the uncertainty that

arises from informational asymmetry. In this case, it refers to the risk that is

essentially associated with an individual's preferences and attitudes towards risk

which are not known to the banker, with the result that uncertainty emerges.

But Stiglitz and Weiss do not address the uncertainty that arises from the time

duration that is involved between the borrower's intention and his success. It thereby

excludes from the model

Page 6: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

4

the uncertainty that arises from unpredictable changes in macroeconomic variables

and from internal competition among firms, factors which influence the success of the

project.

Thus their model is not based on an investigation of factors that determine the risk of

projects, nor does it investigate whether the changes in the interest rate affect the

riskiness of the project. However, given the risk of each respective project, risk

differentials between projects play a crucial role in determining the riskiness of the

loan. This is expressed through the assumption of the incentive effect, that is, changes

in the interest rate introduce the possibility of switching from lower risk to higher risk

projects. Thus the non-disclosure of information mainly refers to the case when

borrowers do not reveal their intention as to whether or not they will switch between

projects in the event of changes in the interest rate.

However, when this possibility evaporates due to the involvement of a high switching

cost between projects, the importance of adverse selection emerges. This is because a

higher interest rate reduces the borrower's net expected rate of return in the event of a

successful outcome of the project. This suggests that the demand for loans should fall.

However, under this circumstance, if any borrowers ask for a loan, this implies that

those borrowers must be borrowing with a preconceived notion that their probability

of repaying the loan is low. Thus, the two assumptions are mutually exclusive and this

provides an explanation why in the presence of an excess demand for loans, bankers,

instead of raising the interest rate, may ration credit.

Page 7: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

5

However, it will be shown (or argued) that when the large pool of borrowers cannot

switch between projects due to the presence of a high switching cost, they do not fall

within the domain of the adverse selection effect. This is because the fundamentals of

the adverse selection effect are violated. That is, the proposition that borrowers are

less likely to lose in the event of a project failure does not in general apply to those

who are already engaged in a project. This excludes a very large pool of borrowers

who may have been rationed due to changes in the interest rate, and this cannot be

explained within the framework of the asymmetric information constraint model.

I

Different borrowers have different probability pay-off attributes and these attributes

may be personal characteristics, as in Jaffee and Russell (1976), or some parameter of

any earning distribution, as in Stiglitz and Weiss (1981). However, lenders know less

than borrowers about borrowers' probability of payoff attributes. Thus the presence of

informational asymmetry is likely to have an impact on the functioning of the credit

market.

In the presence of an uncertain outcome, as individuals' attitudes towards risk are

largely influenced by their own pecuniary (i.e. financial) situations, it is reasonable to

argue that those who have less to lose in the event of an unsuccessful venture will be

more willing to undertake risk. It is on the basis of this premise that the central

conclusion emerging from Stiglitz and Weiss is that the interest rate that banks charge

may itself affect the quality of loans, and that the interest

Page 8: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

6

rate alone may not be capable of clearing the market. Therefore a form of credit

rationing must occur. This conclusion is derived from the following two key

assumptions.

The first is that different levels of interest rate attract different types of borrowers with

different probabilities of repaying the loan. Thus a combination of borrowers may

change adversely in the event of changes in the interest rate. This is based on the

presumption that the higher interest rate may attract borrowers who have a

preconceived notion that their probability of repaying loans is low. Thus a higher

interest rate in general may attract more risky borrowers. This effect is referred to as

the adverse selection effect. The second assumption is that the interest rate on loans

reduces investors' retainable rate of return on a project that succeeds, so that a higher

interest rate may induce firms to undertake projects whose rate of return is high but

which have a lower probability of success. This assumes a linear relationship between

risk and return, i.e. a risky project offers a higher rate of return with a lower

probability of success, thus representing a lower probability of repayment. This is

referred to as the incentive effect.

Both effects stem directly from the residue of asymmetric information which persists,

even after the evaluation of the loan applications. Both effects emerge as a result of

the non-coincidental interest between banks and borrowers. This in turn creates

difficulties for banks to distinguish between risky and relatively less risky borrowers.

Page 9: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

7

Nor do the banks have much control over borrowers' actions. Stiglitz and Weiss argue

that as the interest rate itself affects the riskiness of loans (i.e. the quality of loans), it

is possible to introduce the interest rate as a screening device through which banks

may be able to distinguish between risky and relatively less risky borrowers. That is,

as interest rates rise the average riskiness of the loan increases, thereby reducing

banks' expected profitability.

Consequently, this implies that the supply of loans is a decreasing function of the

interest rate. That is, the initial increase in the interest rate may raise the supply of

loans as it increases the banks' expected profitability. However they are not

represented by a monotonic relationship. Beyond a certain point, as interest rates rise,

banks' expected profitability increases at a declining rate, reaches an optimal point and

then falls as interest rates rise. The optimal point is where the banks' expected

profitability equals the interest rate. This is defined as the equilibrium point, see

Figure 1.

Page 10: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

8

However at Z an excess demand for loans may persist,1 leading to a further rise in

interest rates. Consequently interest rates exceed the expected profitability of bankers.

Thus banks refuse to lend beyond this equilibrium point, as banks' expected

profitability falls, as shown in the above figure. Thus beyond a certain point, even if

the interest rate increases, or even if there is an excess demand for loans in the market,

banks will refuse to lend. This is because as explained, the interest rate itself affects

the nature of the loan transaction (i.e. the quality of loans) and consequently price

may not clear the market, as banks attempt to minimise the difference between their

anticipated and actual rates of return.

II

A careful examination of the above two assumptions will suggest that the interest rate

can only be useful as a screening device to distinguish between risky and less risky

borrowers, when borrowers' behaviour is the only factor that determines the riskiness

of loans. In all other cases a difficulty remains in deploying the interest rate as a

screening device, even though it may affect the quality of loans. This raises questions

in relation to the applicability and the va lidity of these two assumptions, which are

now examined.

Firstly, the assumptions presume that those who are willing to borrow at a higher

interest rate do so because they have a pre- conceived

1 The excess demand for loans may persist either due to businessmen's higher

expected rate of return or due to a higher demand for. working capital in order to

prevent the collapse of businesses.

Page 11: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

9

notion that their probability to repay the loan is low. This raises the issue that if

individuals borrow with this preconceived notion that their probability to repay the

loan is low, why will they be concerned with the level of interest rates? This may

suggest that changes in the interest rate in either direction should not affect the total

number of risky borrowers. Rather it should only affect the number of less risky

borrowers, that is, a higher interest rate will induce less risky borrowers to leave the

loan market, whilst a lower interest rate will attract relatively less risky borrowers.

Thus, although changes in the interest rate affect the combination of borrowers, they

do not affect the total number of risky borrowers. The total number of risky borrowers

remains unaltered in any pool of borrowers, irrespective of the level of interest rates.

This indicates that when interest rates affect the combination of borrowers adversely,

the total number of borrowers falls too. This may be directly attributed to the inverse

relationship between interest rates and the demand for loans. The above argument is

similar to the conclusion reached by Freimer and Gordon i.e. offering higher interest

rates would not generate much demand, “...while it may encourage borrowers to

negotiate loans within this limit at a lower interest rate” (1965, p.416). Alternatively

we can say that this leaves only the most risky borrowers remaining in the pool of

loan applicants and it is only they who are left to be rationed, since it is only they who

have an excess demand. Consequently, this allows Riley to conclude that “...the extent

of rationing implied by S-W model is not likely to be very important empirically”

(1987 p.226).

9

Page 12: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

10

This leaves us with the incentive effect. Stiglitz and Weiss argue that a higher interest

rate induces firms to undertake projects whose expected return is high with a lower

probability of success. This argument is similar to Allias's paradox. Allias argues that

decision makers show a strong preference for the risk aversion principle when

choosing between the proximity of certainty and an uncertain outcome. However,

preferences change when decision makers are confronted with two projects which

both offer uncertain outcomes. Decision makers in general show a strong preference

for more risky ventures. This is especially in the case when risk differentials between

two projects are marginal, but return differentials are great in the event of success.

This principle implies that when the interest rate increases, this reduces borrowers'

expected net return, and all things being equal, this will change the balance of the

risk/return relationship. That is, a reduction in the expected net return will change the

relative position of the risk. Thus when a project is relatively risky in relation to the

net return it offers, this may induce the person to switch to a higher risk project where

the net return is high in the event of success. From the above analysis, it follows that

the selection of a project varies with the level of interest rates. This is possible for

those who are considering a number of projects but have not committed themselves to

any particular one. However this may not be applicable for those who are already

committed to a particular project, because it is necessary for them to take into

consideration the selection and switching costs of the project. The issue of the

switching cost arises mainly as a

Page 13: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

11

result of the fact that investment expenditures are largely irreversible. That is, they are

mostly sunk costs and therefore cannot be recovered. Thus if a firm wishes to switch

from a low return to a high return project, (which means switching from one industry

to another industry), it must take into consideration the net loss that would accrue due

to the sunk cost from the old project. This is because a firm's capital (i.e. plant and

equipment), marketing techniques and advertising techniques are all specific to that

industry. They will therefore have little or no use in other industries, and so in their

present form they are sunk costs. In principle a firm should be able to sell its plant and

equipment to any other firm which is involved in that specific industry. However, as

the value of plant and equipment will be about the same for all firms within that

industry, it is unlikely that one firm will gain much if anything at all from selling it.

Furthermore, in the event of changes in the interest rate, if a firm considers that its

current project's net rate of return is not sufficiently high due to high interest rates,

then this view should be shared by all firms within that industry. Therefore all firms

from that industry would have the same inducement effect, that is they all would like

to switch from low return to high return projects. In these circumstances, firms will

either have no buyers for their plant and equipment, or will be forced to sell well

below its current market value in order to induce other firms to buy it. In either case it

suggests that a switch between projects involves substantial loss to a firm, due to the

Page 14: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

12

irreversible cost. It follows that once the incorporation of the switching cost as well as

the selection cost is completed, that firm's net expected rate of return may not rise

sufficiently to induce them to switch from low return to high return projects, even

when the new project offers a higher expected rate of return.2

This suggests that switching between projects in the event of changes in the interest

rate is possible provided it is assumed that capital is malleable, since malleable capital

does have properties that eliminate the additiona l costs involved in switching.

However Garegnani (1983) argues that at any given instant available physical capital

cannot be fluid, so it cannot take an appropriate form to adjust to the new level of

interest rates. The above argument therefore implies that it is unlikely that existing

firms who are already committed to projects will be able to switch from projects with

low returns to projects with higher returns, without incurring heavy expenses. The risk

of default may therefore remain high in the event of high interest rates, irrespective of

the choice of project, i.e. whether they choose to remain in the old project or switch to

a new one.

Furthermore, the higher expected rate of return and the risk are not the only two

criteria on the basis of which entrepreneurs select their projects. They are also

influenced by their knowledge and familiarity with that project. In most cases,

entrepreneurs do not have sufficient information in relation to

2 For further details see Pindyck (1991).

Page 15: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

13

all projects available to them, leading them to select the project they know best, and

this is to some extent irrespective of the level of interest rates. These two cases

suggest that limitations in the selection of a project remain even after changes in the

interest rate, due either to unfamiliarity with the other available projects or to the

additional cost involved in switching form one project to another.

This leaves Stiglitz and Weiss with a relatively small number of firms who are not

committed to any projects and therefore able to switch between projects.

On the other hand, firms which are already committed to a project are unlikely to fall

within the adverse selection model. These firms have invested a considerable amount

of their own resources and energy and are unlikely to be in a situation where they

have less to lose in the event of the failure of their project. In addition, if the fact is

considered that firms in general have to provide collateral or some form of security in

order to obtain loans, then the argument of having less to lose disappears.

Furthermore, as the loan market operates on the basis of trust and past track records

(or the borrower's standing position with the lending authority), those who borrow

with a preconceived notion that their probability to repay the loan is low cannot be

considered as characteristic of the general borrowing population, since this default

would eliminate the possibility of these borrowers obtaining future loans.

No matter how we examine the problem of adverse selection, it does not appear to be

a realistic assumption. It applies only in

Page 16: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

14

special situations, where firms know that without a loan there is certainty that the

business will collapse but that with a loan there is a slim possibility of survival. Even

under these circumstances, it is unlikely a firm will borrow with such a preconceived

notion, as it would be better to sell the business to minimize the loss, thereby

preserving the individual's track record as a sensible businessman.

This then may suggest that, even if the adverse selection effect or incentive effect

occurs due to changes in the interest rate, these effects are likely to occur only among

a small proportion of the total borrowing population. Thus the rationing that is

generated by Stiglitz and Weiss's model is unlikely to represent the extent of rationing

occurring in the real world.

III

Stiglitz and Weiss's model is based on the asymmetric information constraint. This

constraint refers to those problems that arise mainly due to non-disclosure of

information. In this case uncertainty for bankers results mainly from the fact that

borrowers do not disclose all the necessary information required by banks in the

evaluation of the risk involved in each loan. Thus borrowers know more about their

probability of loan repayment than do bankers.

This provides us with two possible situations where banks can either overestimate or

underestimate risk, the reby leading to either an under-or over-allocation of credit.

Banks will be mainly concerned about the underestimation of risk. To avoid this

underestimation, bankers are required to investigate

Page 17: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

15

borrowers' current rates of return, or the total volume of their yearly sales and their

size of operation. However, in the absence of any indirect avenue to obtain such

information, bankers may have to rely upon borrowers' honesty. In fact borrowers

may provide misleading information, distorting and diffusing the bankers' process of

risk evaluation, leading to deceptive information in relation to the probability of loans

repayment. Bankers are left with only one option and that is to investigate individuals'

attitudes toward risk, and whether their attitudes toward risk change when the interest

rate increases. Thus the importance of adverse selection and incentive effects come

into play.

However, the problem is that this overlooks the other factors that also contribute to

the determination of the individuals' total risk and thereby leaves out an important

vehicle through which one can in general distinguish between relatively less risky and

riskier borrowers. For example, as every firm in a industry competes with its rivals in

order to increase its own market share, competition among firms may bring about a

unforeseen risk of failure for any firm. Given the market demand, if an individual firm

is able to increase its own share, it would mean some other firm may not be able to

increase its own share as originally anticipated. As a matter of fact some firms may

even lose their share. If all firms have equal shares or equal size of operations, then

each individual firm will have an equal chance of increasing or losing its own share.

Thus risk could be equally distributed, and project risk and firm

Page 18: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

16

risk may become identical. Consequently firms' risk could be represented by project

risk only. If firms within an industry do not have equal shares, the probability of each

individual firm losing or increasing its own share in the market will differ between

firms, so that risk could not be distributed equally. That is, some firms may present a

greater risk than others within the industry. Thus the risk that is generated by internal

competition, whether it will be equally distributed or unequally distributed among

firms within the industry, will be determined by the specific market structure. As

modern industry is mostly represented by some form or another of oligopolistic

phenomena, it is not viable to ignore the risk that emerges from specific competitive

market structures.

The existence of differential scales of operation within the industry introduces the

possibility for firms of unequal size to obtain heterogeneous rates of return and to

have different probabilities of obtaining these rates. Thus, given that the estimated

mean value of unequally sized firms represents different values of variance associated

with their earnings, unequally sized firms would represent different levels of risk.

This implies that the mean value of a project is an average value of all firms within

the industry, thus hiding a significant variation within the estimated mean value, and

also the probability of obtaining such a value. It follows that an individual's size of

operation, in relation both to his competitors and to the total size of the market, has an

important bearing upon determining the degree of his risk in relation to

Page 19: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

17

the project risk, that is, whether the individual is above or below the mean value of the

project risk. This suggests that an individual's risk cannot be represented purely by

considering the mean value of the project risk.

In fact the size of operation appears to be an important criterion for banks to use in

order to decide to whom to lend, and how much to lend, as is evidenced by the fact

that smaller sized firms always have less access to the loan market. Furthermore,

when the interest rate increases it is normally the smaller sized firms whose access to

the loan market is reduced. This was observed in the United States between 1955-57,

when both the demand for loans and the interest rate remained high, and banks

refused to lend to small business [Grey and Brockie (1959), Basu (1989)].3 Grey and

Brockie noted that during the period from 1955-57 when the interest rate was

generally rising, it rose less for smaller-sized firms while, at the same time, the

volume of borrowing by smaller-sized firms did not increase to the same extent as that

by larger enterprises (1959, p.340). One may tend to conclude that perhaps the smaller

firms are more interest elastic than larger firms. However, evidence suggests that the

credit-worthiness of the borrower may remain as the primary importance in credit

allocation. This was based on the observation which suggests that “the young firm has

a greater

3 See also Japelli (1990), where the author found that individuals' access to loans is

largely determined by their income. Thus a general rise in interest rates, while income

is held constant, will naturally reduce access to the loan market for those who receive

a lower income.

Page 20: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

18

demand for. funds than the older firm because it is expanding more rapidly in size and

the young firm is generally a small firm”. (Grey and Brockie, 1959 pp. 339-40).

It is difficult to conclude from the above observation whether or not the higher

interest rate affected the aggregate supply of loans, but there is no evidential difficulty

in concluding that the higher interest rate at least affected the distribution of loans.

The distribution of loans is largely affected by the expected adverse impact on the

smaller borrower which is caused by a higher interest rate. This is because banks

believe that smaller and some medium size borrowers' average future profit may not

be sufficient to cover the interest rate.

This course of action by banks follows from two probable beliefs. The first is that

smaller or medium sized firms will be unable to capture a sufficient share of the

growing market. This is due to the presence either of large firms or of too many small

firms with easy entry which prevents smaller and medium sized firms from enhancing

their income enough to pay the higher interest rate. The second belief is that the

higher demand for products leading to a higher price in general is also accompanied

by a higher input price, so that if the share of the market does not increase sufficiently

to offer the advantage of economies of scale in the use of inputs, then the expected

profit from these businesses may not rise sufficiently to cover the interest bill. Neither

of the above cases suggests that banks' denial of loans to smaller and medium size

business arises from the adverse selection effect and incentive effect. Rather it occurs

due to

Page 21: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

19

the fact that this sector has a history of high failure rates, so that banks in general have

less interest in lending to them. Furthermore, during the high interest rate period,

banks become more concerned about the difficulties of small firms in meeting the

interest cost. Stiglitz and Weiss have ignored this issue.

This may be because of the fact that it is not possible to address the risk that emerges

from the size of operation or from the specific competitive market structure within the

asymmetric information framework.

Thus it remains that these authors analyse credit rationing by considering the mean

value of the project risk as representative of the individual's risk. Consequently, the

possibility of switching from lower risk to higher risk projects remains the only

plausible reason for bankers to ration credit when the interest rate changes. However,

when the switching possibility disappears due to the irreversible cost, Stiglitz and

Weiss's model cannot explain why bankers ration credit when the interest rate

increases.

Besanko and Thakor (1987) have investigated credit rationing by incorporating the

market structure, with reference to the lender's monopoly and a perfectly competitive

market structure, but were unable to generate much rationing. This is because they

also assume that the project risk and borrowers' risk are identical. That is, if we

assume that the borrower is a monopoly firm the firm's risk will be represented by the

project risk. On the other hand if we assume that borrowers operate under a perfectly

competitive market, then by assumption, any variation

Page 22: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

20

in the size of operation is eliminated. Again, project risk can be used as representative

of the firms' risk. It is no wonder that Besanko and Thakor too found that the extent of

rationing that is generated by their model or by Stiglitz and Weiss's model is less than

that observed in the real world.

At the beginning of this paper it was mentioned that asymmetric information does not

address the risk and uncertainty that arise due to the time between the borrower's

intention and his success. Intention is generally influenced by past and current

experience, and in this case, the decision to invest in any particular I project is

determined by the past and current outcome of the project and by the investor's

familiarity with such a project. Thus, the project risk is calculated on the basis of

objective information available at that time. However, once the decision is taken to

invest in such a project or in another project, objective information alone is no longer

valid for the purpose of estimating future risk. This is because we do not have factual

information concerning the future values of those variables whose movements will

ultimately determine the project outcome. Calculation of risk for a project's future

outcome involves projecting forward in time, not moving backward in time. Risk

that is past can be calculated with objective information, but in the case of future risk

we do not have factual information, and consequently risk calculation is essentially

based on subjective evaluation. It is because of this factor that even after the

evaluation of a loan application or a project evaluation one cannot determine the

precise magnitude of the risk involved in such a project.

Page 23: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

21

Asymmetric information attempts to address the risks that are associated with the past,

that is, the information is there but uncertainty emerges because borrowers do not

reveal the total information in relation to the project's past and current performance as

well as the ir true intention. For example, suppose a farmer is borrowing for a seed

plantation. The farmer knows that he should not plant a high yielding variety in non-

irrigated land nor should he plant drought resistance seeds in irrigated land. He also

knows which seed should be planted in which season. Planting seeds in unsuitable

land and in an unsuitable season will influence the outcome of his output, thereby

affecting the riskiness of the loan. This information is known to the farmer from his

past experience but he does not reveal it to the lender, when he provides a general

outline of the project. Thus, the way the farmer will implement his project is not

known to the lender nor can the lender monitor it. According to Stiglitz and Weiss's

model it could be argued that changes in the interest rate that reduce the farmer's net

return may provide an incentive for farmers to switch from one seed to another, which

has a higher probability of failure but which in the event of success will produce a

greater yield. Thus, a higher interest rate introduces the possibility of the emergence

of the adverse selection and incentive effects.

It is doubtful whether the actual farmer would behave in this way. However, we can

give good reasons why farmers in general would not behave in this manner even when

the interest cost increases.

Page 24: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

22

The farmer's net rate of return may be reduced due to higher interest costs, but there is

still some return and this allows the farmers to enjoy ownership of their own land.

Switching to a more risky seed exposes them to the possibility of losing their land,

since they have to mortgage part of it to obtain the loan.

Observation reveals that farmers in general by nature prefer to avoid risk just like

businessmen. It took quite a significant time for the government of India to convince

farmers that the high yielding variety programme would benefit them. Similarly,

Australian farmers during the mid-1980s when they knew farming did not have a

good future in Australia, did not sell their property and invest in the money market

nor in government bonds that would earn more income than they derived from their

current occupation. They held on to their land because farming was what they knew

best. Thus, it is extremely unlikely a farmer will undertake more risky projects in the

event of changes in the interest rate. Most businessmen as well as farmers prefer

techniques and projects that they know best. Consequently, technological diffusion or

new product introduction take longer periods to introduce and bankers also show their

reluctance to lend for the adoption of a new technique or a new product. This then

may explain why a banker does not take much interest in how a farmer or a

businessman will implement a project, or in f monitoring the business. In addition,

monitoring a business requires specific knowledge about that business which most

bankers lack.

Page 25: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

23

What are the factors that introduce risk and uncertainty in relation to a project's

outcome? The main risk and uncertainty for farmers, for example, emerges from the

unpredictable nature of the weather affecting output and the future output price.

Future price is not only determined by the price of production (i. e. cost of production

plus mark-up, where mark-up includes interest cost as well), but also by the demand

conditions prevailing at that time. These are known neither to the farmer nor to the

banker. These uncertainties mainly emerge due to the time duration between the

planting of seeds and the harvest, within which time many conditions may change

thereby either affecting the output or the price.

Even if the farmer revealed all his information to the bankers, neither the farmer nor

the banker would be able to determine the precise magnitude of the risk involved in

each loan. It is this fact that will influence the design of contracts, rather than the

adverse selection and incentive effects. Accordingly, bankers ask for collateral or

security against loans. Thus, access to the loan market is not only determined by the

borrowers' willingness to pay the interest rate, but whether they can provide the

required collateral and their standing position with the banking authority. This then

may suggest that in addressing the issue of why bankers ration credit, it may be

necessary to ask why the interest rate alone can determine the distribution of loans

rather than why stickiness is observed in the interest rate. It is the analysis which may

allow development of a theory that may explain the extent of rationing that exists in

the loan market.

Page 26: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

24

References

Allias, M. (1987) - "Allias Paradox" in New Palcrrave A Dictionary of Economics,

Vol 1, ed. by J. Eatwell, M. Milgate and P. Newman, MacMillan.

Andrews P.W.S. (1951) - "A further Inquiry into the effects of Rates of Interest" in

Oxford Studies in the Price Mechanism, ed. by Wison, T. and Andrews P.W.S.,

Oxford at the Clarendon Press.

Basu S. (1989) "Deregulation, Small Business Access to the Capital Market -

Theoretical Issues with Special Reference to Australian Bank Finance", Australian

Economic Papers Vo1.28, pp.141-159.

Besanko D. and Thakor A.V. (1987) "Collateral and Rationing: Sorting Equalibria in

Monopolistic and Competitive Credit Markets", International Economic Review, Vol.

28 pp 671 - 689.

Bester H. (1985). "Screening vs Rationing in Credit Market with Imperfect

Information", American Economic Review, Vol 75, pp.850-55.

Blinder A. and Stiglitz J. (1983), "Money Credit Constraint and Economic Activity",

American Economic Review, Vol 73 pp 297 - 302.

De Mezza D. and Webb D.C. (1987), "Too Much investment: A Problem of

Asymmetric Information" Quarterly Journal of Economics Vol 102. pp 281 - 292.

Page 27: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

25

Freimer M. and Gordon M. (1965), "Why Bankers Ration Credit" Quarterly Journal

of Economics Vol. 79 pp 397 - 416.

Garegnani P. (1983), "Notes on Consumption Investment and Effective Demand" in

Keynes's Economics and the Theory of Value and Distributions ed. by J. Eatwell and

M. Milgate, Duckworth.

Grey A.L. and Brockie J.M.D. (1959), "The rate of Interest,

Marginal Efficiency of Capital and Investment Programming – A rejoinder",

Economic Journal, Vol 69, pp 333 - 343.

Jaffee D.M. and Russell T. (1976), "Imperfect information, uncertainty and Credit

Rationing" Quarterly Journal of Economics Vol. 90 pp 651 - 666.

Jaffee D.M. and Stiglitz J. (1990) - "Credit Rationing" in Handbooks of Monetary

Economics, B Briedman and F. Hahn (eds.), Vol.II, North Holland.

Japelli T. (1990), "Who is credit constrained in the U.S. Economy?" Quarterly Journal

of Economics Vol. 105, pp 219 - 234.

Pindyck R.S. (1991) "Irreversibility, uncertainty, and investment", Journal of

Economic Literature Vol. 29, pp 1110-1148.

Riley J. (1987), "Credit Rationing: A further remark", American Economic Review,

Vol 77, pp 224 - 231.

Page 28: ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE · Asymmetric information, credit rationing and the Stiqlitz-Weiss Model By Santonu Basu∗ In the last decade Stiglitz and Weiss

26

Stiglitz J.E. and Weiss A. (1981), "Credit Rationing in Markets with Imperfect

Information", American Economic Review Vol 71, pp.393-410.

Stiglitz J.E. and Weiss A. (1987), "Credit Rationing: Reply" American Economic

Review, Vo1.77 pp.228-231.