Borrowing Constraints and Portfolio Choice

Abstract

This paper examines how borrowing ceilings in the personal loan market affect the portfolio choice of consumers. Most papers on borrowing constraints do not address the question of portfolio choice: it is typically assumed that all assets can be liquidated to finance consumption in the case of an income shortfall.' In this case, borrowing ceilings will never bind until consumers have run their assets down to zero and borrowed up to their limits. However, it may be more realistic to assume that consumers have a choice of allocating wealth between short-term liquid assets (e.g., cash) that can be used for current consumption purposes, and longer term illiquid assets (e.g., housing equity, CDs) that cannot be used for current consumption purposes but may be used as collateral for loans. The central question of this paper is whether the presence of borrowing ceilings in the personal loan market will induce individuals to hold a larger share of their assets in liquid form. This question is addressed within the context of two types of borrowing ceilings. First, it is assumed that borrowing ceilings are exogenous, in that they are unaffected by the individual's portfolio choice. This assumption is similar to that made in many papers on borrowing constraints.2 The presence of exogenous borrowing ceilings will unambiguously lead to more liquid portfolios. Individuals who know that there is a limit to the amount that can be borrowed will hold a larger share of their wealth in liquid form, since by doing so the probability of becoming credit constrained in the future is reduced. The case of exogenous borrowing ceilings is contrasted with the case in which borrowing ceilings are due to interest rate ceilings in