asymmetric information, credit rationing and the · asymmetric information, credit rationing and...
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ASYMMETRIC INFORMATION, CREDIT RATIONING AND THE
STIGLITZ AND WEISS MODEL
SANTONU BASU
SCHOOL OF ECONOMIC AND FINANCIAL STUDIES
MACQUARIE UNIVERSITY
1992
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.
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.
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
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.
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
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.
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.
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.
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
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
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
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).
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
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
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
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
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.
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
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
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.
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.
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.
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.
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.
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