ASYMMETRIC INFORMATION IN CREDIT MARKETS AND ITS IMPLICATIONS FOR MACRO-ECONOMICS

Abstract

competition.' In Stiglitz-Weiss (1981, 1983), we developed a theory of credit rationing. We argued that banks might not increase the interest rate they charged even in the face of an excess demand for funds, for to do so might reduce their expected rate of return because the probability of default would increase. Two reasons were presented for the possible inverse relationship between the rate of interest charged and the expected return to the bank: higher interest rates reduce the proportion of low risk borrowers (the sorting effect to which Smith had called attention) and higher interest rates induce borrowers to use riskier techniques (the incentive effect).2 We argued that collateral and other non-price rationing devices would not eliminate the possibility of credit rationing. Increasing collateral requirements makes borrowers less willing to take risks, which increases the return to the bank. On the other hand, increasing collateral requirements may adversely affect the mix of applicants.3 Even if all individuals had the same utility functions and faced the same investment opportunities, wealthier individuals would both be willing to put up more collateral and would undertake riskier projects than would less wealthy individuals if there was decreasing absolute risk aversion.4 Moreover, if large wealth accumulations are the result of risk-taking plus luck, a disproportionately large fraction of the very wealthy those who would put