Volume 43, Number 171,
October-December 2012
Credit Rationing:
A Perspective from New Keynesian Economics
Abigail Rodríguez and Francisco Venegas

Jaffee and Russell’s proposal initiated a new representation of credit supply and demand (Figure 2). Specifically, it highlights that in the situation where the client does indeed pay and when credit supply and demand coincide, in other words in E (absence of rationing), R > I, the bank obtains higher yields for a loan of resources than its cost. This surcharge compensates for the risk of default. If the credit is granted at any point along the ITE (thick line) line, below the demand curve, credit is rationed. Honest individuals may prefer any amount of resources in segment TE because the active rate required is lower, but ideally they would prefer the area where the straight line TE is tangent to the highest indifference curve U2.6

Figure 2. Equilibrium and Credit Rationing with a Probability of Default and Adverse Selection
Source: Adapted from Jaffee and Russell (1976).

One of the most well known works is from Stiglitz and Weiss (1981), who distinguish between the effects of adverse selection and the effects of adverse incentives in the credit relationship. With these, the authors try to show that the bank’s decisions have an effect on the client’s decisions and that this in turn affects the results expected by the bank.

Adverse selection and adverse incentives originate because even though banks recognize that clients have different probabilities of payment, they cannot differentiate between them. However, one strategy to identify them is to observe the change in the demand for resources as a response to changes in the active interest rate.7 Adverse selection occurs when the bank increases the required active rate because the credit applicants maintaining the demand are the most risky, and the clients with greater probability of repayment withdraw their credit applications. This makes it feasible for the bank to obtain greater expected income by demanding elevated interest rates and granting resources to the most risky clients.8

The problem with adverse incentives occurs when the banks decide to increase the required active rate, because this makes companies carry out projects with lower probabilities of success, as well as the most risky projects, because they guarantee greater economic results if they are successful. This attitude of potential clients, who modify their demand for credit in the face of the bank’s demands, implicitly recovers the distinction between borrowers proposed by Jaffee and Russell (1976). However, in this case, it is emphasized that their behavior responds to optimization of benefits in their role as businessmen.9

6Observe the difference in the graphical representation of Hodgman’s (1969) and Jaffee and Russell’s (1976) proposals. In the former, rationing is the difference between credit supply and demand at the optimal interest rate. Graphically, this is the space to the right of the supply curve and to the left of the demand curve. Because the supply and demand curves do not cross each other, the demand is always to the right of the supply curve. The amount of credit is determined over the supply curve where the interest rate is optimal. For Jaffee and Russell (1976), the desired demand does indeed cross the supply curve, but resources are granted for an amount below what is desired. Graphically, rationing is the difference between the desired supply and demand at any interest rate less than or equal to the optimal rate, but greater than the cost rate for the resources.

7 Stiglitz and Weiss (1981) believe that the yield rate is a positive decreasing function of the interest rate (like in Figure 1). The rate that maximizes expected yield is the equilibrium rate (even if supply and demand for resources do not coincide).

8Stiglitz and Weiss’s (1981) model is based on the assumption that credit applicants are risk averse. Wette (1983) demonstrates that adverse selection is also possible between neutral agents of risk.

9To extend the analysis of the problems resulting from increasing the interest rate above the equilibrium level, Stiglitz and Weiss (1981) examine the effects of demanding greater collateral (own capital) from companies as a guarantee of payment. By increasing the collateral, the bank’s expected yield may be reduced, because the bank increases the borrower’s level of risk aversion, or because the investors opt for more risky projects. This result considers that the agents with lowest risk aversion are those that have the most capital and are willing to offer part of it as collateral. Because the borrowers have more information than the lenders, because they know the quality of their investment projects (possible profitability and risk), this may motivate certain actions from the bank to its benefit. For example, in active contracts with multiple periods, it may occur that the end of the first period observes a higher yield than expected for the project and than what was expected by the bank. But the success of the project may require a new credit assignment in the second period. If this is the case, the bank may decide to lend a new amount, which may generate positive yields, or it may decide not to renew the loan, which will surely incur losses. If when renewing the credit line the bank demands an active rate lower than the equilibrium, the borrower will most likely opt to finance safe projects. However, if the demanded rate is greater than the equilibrium rate, the borrower will prefer riskier projects.

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PROBLEMAS DEL DESARROLLO. REVISTA LATINOAMERICANA DE ECONOMÍA, Volume 49, Number 194 July-September 2018 is a quarterly publication by the Universidad Nacional Autónoma de México, Ciudad Universitaria, Coyoacán, CP 04510, México, D.F. by Instituto de Investigaciones Económicas, Circuito Mario de la Cueva, Ciudad Universitaria, Coyoacán,
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