Government Lending As a Tool to Mitigate the Effect of Asymmetric Information

Abstract

This paper analyzes the effect of asymmetric information on investment efficiency and the ways in which government credit can mitigate the inefficiency caused by asymmetric information. The inefficiency caused by asymmetric information critically depends on the way in which the project return is related with the project risk. To produce more general results, I assume that the project return and the project risk are independently distributed random variables. Under this assumption, asymmetric information produces two type of inefficiency: exclusion of good borrowers and inclusion of bad borrowers. Asymmetric information results in investment inefficiency by making the borrower composition in the sector where information is opaque (opaque sector) suboptimal and under-allocating credit to the opaque sector. In the case of credit rationing, the government can improve the borrower composition and the sector allocation using a subsidy, thereby improving investment efficiency. The most interesting result is a positive effect of a higher lending rate on investment efficiency. Government credit is much more likely to improve investment efficiency when the lending rate is set at a level above the private lenders' profit-maximization level than when the lending rate is set at a level below it. When lenders raise the lending rate, borrowers with a higher repayment probability drop out because the borrowing rate adjusted for the repayment probability (adjusted borrowing rate) is higher, and borrowers with a lower project return drop out because they cannot afford to pay a higher borrowing rate. Thus, a higher lending rate is likely to improve the borrower composition in terms of the average project return. The best way to deal with credit rationing, therefore, is to set the lending rate at a high level (low adjusted lending rate) to weed out low-return projects, bid up the funding rate to increase the loan volume in the opaque sector, and make up the difference between the high funding rate and the low adjusted lending rate with a subsidy. In this way, the government loan can accommodate many high-risk, high-return projects. This result is a dramatic deviation from the conventional notion of a subsidized loan, which almost automatically means a lower lending rate. A subsidized loan guarantee covering a moderate portion of loan losses can deliver similar outcomes.