Credit Rationing

Definition

Credit rationing refers to the situation where lenders limit the amount of credit they are willing to provide to borrowers, even when the borrowers are willing to pay higher interest rates. This phenomenon occurs in financial markets due to information asymmetries and the risk of adverse selection.

5 Must Know Facts For Your Next Test

1. Credit rationing can occur when lenders are unable to fully assess the risk of borrowers, leading them to limit credit supply to protect against potential losses.
2. Lenders may ration credit to avoid the risk of adverse selection, where high-risk borrowers are more likely to seek out and obtain loans.
3. Information asymmetry between lenders and borrowers can contribute to credit rationing, as lenders may have difficulty distinguishing between high-risk and low-risk borrowers.
4. Moral hazard can also play a role in credit rationing, as borrowers may take on additional risk if they know they are protected from the consequences.
5. Credit rationing can have significant implications for economic activity, as it can limit access to capital and constrain investment and consumption.

Review Questions

• Explain how information asymmetry between lenders and borrowers can lead to credit rationing.
  • Information asymmetry refers to a situation where one party in a transaction has more or better information than the other. In the context of credit markets, lenders may have difficulty fully assessing the risk of borrowers due to this information imbalance. As a result, lenders may choose to ration credit by limiting the amount of loans they are willing to provide, even if borrowers are willing to pay higher interest rates. This helps lenders protect against the risk of adverse selection, where high-risk borrowers are more likely to seek out and obtain loans.
• Describe the role of moral hazard in the context of credit rationing.
  • Moral hazard can also contribute to credit rationing. Moral hazard refers to the risk that a party may take on additional risk because they know they are protected from the consequences. In the context of credit markets, borrowers may be more willing to take on riskier projects or engage in riskier behavior if they know they are protected from the consequences by lenders. Lenders, aware of this moral hazard, may choose to ration credit to limit their exposure to these risks, even if borrowers are willing to pay higher interest rates.
• Analyze the potential economic implications of credit rationing and how it may impact overall economic activity.
  • Credit rationing can have significant implications for economic activity. By limiting access to capital, credit rationing can constrain investment and consumption, as businesses and individuals may be unable to obtain the necessary financing for projects and purchases. This can lead to reduced economic growth, lower employment, and a slowdown in overall economic activity. Additionally, credit rationing may disproportionately affect certain sectors or segments of the population, further exacerbating economic disparities. Policymakers may need to address the underlying causes of credit rationing, such as information asymmetries and moral hazard, in order to promote more efficient allocation of credit and support broader economic development.

Related terms

Adverse Selection: The tendency for high-risk borrowers to be more likely to seek out and obtain loans, leading to a pool of borrowers with higher overall risk.

Information Asymmetry: A situation where one party in a transaction has more or better information than the other, leading to an imbalance of power in the transaction.

Moral Hazard: The risk that a party may take on additional risk because they know they are protected from the consequences, often due to information asymmetry.