Credit rationing in Markets with Imperfect Information By JOSEPH E STIGLITZ AND ANDREW WEISS* Why is credit rationed? Perhaps the most they receive on the loan, and the riskiness of basic tenet of economics is that market equi- the loan. However, the interest rate a bank if demand should exceed suang demand; that charges may itself affect the riskiness of the librium entails supply equal rise, decreasing demand and/or increasing borrowers(the adverse selection effect); or 2) supply until demand and supply are equated affecting the actions of borrowers( the incen at the new equilibrium price. So if prices do tive effect). Both effects derive directly from their job, rationing should not exist. How- the residual imperfect information which ver, credit rationing and unemployment do present in loan markets after banks have in fact exist. They seem to imply an excess evaluated loan applications. When the price demand for loanable funds or an excess (interest rate)affects the nature of the trans supply of workers. action, it may not also clear the market One method of "explaining "these condi- The adverse selection aspect of interest tions associates them with short-or long-term rates is a consequence of different borrowers isequilibrium. In the short term they are having different probabilities of repaying viewed as temporary disequilibrium phenom- their loan. The expected return to the bank a; that is, the economy has incurred an obviously depends on the probability of re- xogenous shock, and for reasons not fully payment, so the bank would like to be able explained, there is some stickiness in the to identify borrowers who are more likely to prices of labor or capital (wages and interest repay. It is difficult to identify"good bor rates)so that there is a transitional period rowers, "and to do so requires the bank to during which rationing of jobs or credit use a variety of screening devices. The inter- urs. On the other hand, long-term un- est rate which an individual is willing to pay employment( above some“ natural rate”) may act as one such screening device: the ose credit rationing is explained by governmen- who are willing to pay high interest rates tal constraints such as usury laws or mini- may, on average, be worse risks; they are mum wage legislation willing to borrow at high interest rates be The object of this paper is to show that cause they perceive their probability of re- in equilibrium a loan market may be char- paying the loan to be low. As the interest acterized by credit rationing. Banks making rate rises, the average"riskiness"of those loans are concerned about the interest rate who borrow increases, possibly lowering the bank's profits and Bell Laboratories, Inc, respectively. We Similarly, as the interest rate and other Bell Telephone Laboratories, Inc, and Princeton ms of the contract che the behavior of to thank Bruce Greenwald, Henry Landau, the borrower is likely to change. For in- Rob Porter, and Andy Postlewaite for fruitful cor stance, raising the interest rate decreases the Science Foundation is gratefully acknowledged. An return on projects which succeed. We will version of this paper was presented at the spring how that higher interest rates induce firms 977 meetings of the Mathematics in the Social Science to undertake projects with lower probabili ties of success but higher payoffs whe Indeed, even if markets were not competitive one cessful hopolistic bank to raise In a world with perfect and costless infor the interest rate it charges on loans to the point where mation, the bank would stipulate precisely excess demand for loans was eliminated all the actions which the borrower couldCredit Rationing in Markets with Imperfect Information By JOSEPH E. STIGLITZ AND ANDREW WEISS* Why is credit rationed? Perhaps the most basic tenet of economics is that market equi￾librium entails supply equalling demand; that if demand should exceed supply, prices will rise, decreasing demand and/or increasing supply until demand and supply are equated at the new equilibrium price. So if prices do their job, rationing should not exist. How￾ever, credit rationing and unemployment do in fact exist. They seem to imply an excess demand for loanable funds or an excess supply of workers. One method of "explaining" these condi￾tions associates them with short- or long-term disequilibrium. In the short term they are viewed as temporary disequilibrium phenom￾ena; that is, the economy has incurred an exogenous shock, and for reasons not fully explained, there is some stickiness in the prices of labor or capital (wages and interest rates) so that there is a transitional period during which rationing of jobs or credit oc￾curs. On the other hand, long-term un￾employment (above some "natural rate") or credit rationing is explained by governmen￾tal constraints such as usury laws or mini￾mum wage legislation.' The object of this paper is to show that in equilibrium a loan market may be char￾acterized by credit rationing. Banks making loans are concerned about the interest rate they receive on the loan, and the riskiness of the loan. However, the interest rate a bank charges may itself affect the riskiness of the pool of loans by either: 1) sorting potential borrowers (the adverse selection effect); or 2) affecting the actions of borrowers (the incen￾tive effect). Both effects derive directly from the residual imperfect information which is present in loan markets after banks have evaluated loan applications. When the price (interest rate) affects the nature of the trans￾action, it may not also clear the market. The adverse selection aspect of interest rates is a consequence of different borrowers having different probabilities of repaying their loan. The expected return to the bank obviously depends on the probability of re￾payment, so the bank would like to be able to identify borrowers who are more likely to repay. It is difficult to identify "good bor￾rowers," and to do so requires the bank to use a variety of screening devices. The inter￾est rate which an individual is willing to pay may act as one such screening device: those who are willing to pay high interest rates may, on average, be worse risks; they are willing to borrow at high interest rates be￾cause they perceive their probability of re￾paying the loan to be low. As the interest rate rises, the average "riskiness" of those who borrow increases, possibly lowering the bank's profits. Similarly, as the interest rate and other terms of the contract change, the behavior of the borrower is likely to change. For in￾stance, raising the interest rate decreases the return on projects which succeed. We will show that higher interest rates induce firms to undertake projects with lower probabili￾ties of success but higher payoffs when suc￾cessful. In a world with perfect and costless infor￾mation, the bank would stipulate precisely all the actions which the borrower could *Bell Telephone Laboratories, Inc. and Princeton University, and Bell Laboratories, Inc., respectively. We would like to thank Bruce Greenwald, Henry Landau, Rob Porter, and Andy Postlewaite for fruitful comments and suggestions. Financial support from the National Science Foundation is gratefully acknowledged. An earlier version of this paper was presented at the spring 1977 meetings of the Mathematics in the Social Sciences Board in Squam Lake, New Hampshire. 'Indeed, even if markets were not competitive one would not expect to find rationing; profit maximization would, for instance, lead a monopolistic bank to raise the interest rate it charges on loans to the point where excess demand for loans was eliminated. 393