key term - Credit Rationing

Definition

Credit rationing refers to the phenomenon where lenders limit the supply of credit to borrowers, even when the borrowers are willing to pay the market interest rate. This occurs when lenders perceive the risk of lending to be too high, leading them to restrict the amount of credit they are willing to provide.

5 Must Know Facts For Your Next Test

1. Credit rationing is more likely to occur in financial markets where there is a high degree of information asymmetry between lenders and borrowers.
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. Moral hazard can also contribute to credit rationing, as borrowers who are insulated from the full risk of default may engage in riskier behavior.
4. Credit rationing can lead to a suboptimal allocation of credit, where some creditworthy borrowers are unable to obtain the financing they need.
5. Governments may intervene in credit markets to address credit rationing, such as through the provision of loan guarantees or the establishment of development banks.

Review Questions

• Explain how information asymmetry between lenders and borrowers can lead to credit rationing.
  • In situations where lenders have less information about the creditworthiness of borrowers compared to the borrowers themselves, this information asymmetry can lead to adverse selection. Lenders may perceive high-risk borrowers as more likely to seek out loans, leading them to ration credit in order to limit their exposure to this risk. By restricting the supply of credit, lenders can avoid lending to the riskiest borrowers and maintain the overall quality of their loan portfolio.
• Describe how moral hazard can contribute to credit rationing.
  • Moral hazard occurs when a party insulated from risk may behave differently than they would if they were fully exposed to the risk. In the context of credit markets, borrowers who are insulated from the full consequences of default may engage in riskier behavior, such as investing in high-risk projects or taking on excessive debt. Lenders, aware of this moral hazard, may respond by rationing credit to limit their exposure to this risk, even if some creditworthy borrowers are denied access to financing.
• Evaluate the potential consequences of credit rationing for the overall efficiency of the credit market.
  • Credit rationing can lead to a suboptimal allocation of credit, where some creditworthy borrowers are unable to obtain the financing they need to invest in productive projects. This can have negative consequences for economic growth and development, as valuable investment opportunities may go unrealized. Additionally, credit rationing can exacerbate existing inequalities, as marginalized borrowers may be disproportionately affected by the limited availability of credit. Governments may intervene in credit markets to address these inefficiencies, such as through the provision of loan guarantees or the establishment of development banks, in order to improve the overall efficiency of the credit allocation process.

Related terms

Asymmetric Information:

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.

Adverse Selection:

A situation where high-risk borrowers are more likely to seek out and obtain loans, leading to a higher overall risk profile for the lender.

Moral Hazard:

A situation where a party insulated from risk may behave differently than they would if they were fully exposed to the risk.