The Roles of Adverse Selection and Moral Hazard in

Theories of Credit Rationing.

With a Variant of C. Wilsons Model of Adverse Selection
in the Credit Market.
Dennis Paschke
Course: Financial Intermediation and Financial Systems (EC4406)
Lecturer: Dr D Cobham
Contents 2
Contents
Introduction ________________________________________________________________3
1 C. Wilsons Model of Adverse Selection in the Credit Market ____________________3
2 The roles of adverse selection and moral hazard in theories of credit rationing ________7
3 Why banks ration credit ___________________________________________________8
4 Conclusions____________________________________________________________10
References ________________________________________________________________10
Notes ____________________________________________________________________11
Introduction 3
Introduction
This essay outlines the roles of adverse selection and moral
hazard in theories of credit rationing. Moreover, it outlines why I
believe credit rationing may occur in the real world of banking.
The first section presents the framework of C. Wilsons model
of adverse selection in the credit market. This shows that credit
rationing exists under certain assumptions.
1
The second section
provides arguments why adverse selection and moral hazard may
cause credit rationing. Section three explains why credit rationing
may occur in the real world. Section four summarises and
concludes.
1 C. Wilsons Model of Adverse Selection in the
Credit Market
2
Suppose their are n low-risk borrowers, who borrow B funds
each to invest in a project. They expect a zero or 5/2B (gross)
return with probability 1/2.
There are n high-risk borrowers, who borrow B funds each to
invest in a project. They expect a zero (gross) return with
probability 3/4 and a 5B return with probability 1/4.
Banks require a collateral 2 / B C = deposited with the bank
and an interest rate (gross) of r. If the return of a borrowers
project is greater than B r ) 2 / 1 ( the loan will be repaid. If not,
the borrower defaults and the bank takes collateral C plus
whatever the return of the project was.
Banks supply loans in a quantity equal to the * nB banks
expected rate of return.
Expected profits of the low-risk borrowers are:
2
) (
2
5
2
1
2
0
2
1
) (
rB
B E
rB
B B
E
=

=
C. Wilsons Model of Adverse Selection in the Credit Market 4
The highest interest rate low-risk borrowers would be willing
to pay is:
2
0
2
!


r
rB
B
Expected profits of the high-risk borrowers are:
( )
4 8
7
) (
5
4
1
2
0
4
3
) (
rB
B E
rB B
B
E
=
+

=
Hence, the highest interest rate they would be willing to pay:
2
7
0
4 8
7
!


r
rB
B
Total demand for loans depends on the interest rate. The loan
demand equation is:

>
<

=
2 / 7 for 0
2 / 7 2 for
2 0 for 2
r
r nB
r nB
D
(3
Expected (gross) rate of return of the banks for each range of
the interest rate:
2 0 r :
r r E
rB B rB B
B
r E
rB
B
n rB
B
n
nB
r E
8
3
16
5
) (
4 8
3
2 4
1
2
1
) (
4
1
2 4
3
2
1
2 2
1
2
1
) (
+ =
1
]
1

+ + + =
1
]
1

\
|
+ +
|

\
|
+ =
2 / 7 2 < r :
r r E
rB B
B
r E
rB
B
n
nB
r E
4
1
8
3
) (
4 8
3 1
) (
4
1
2 4
3 1
) (
+ =
1
]
1

+ =
1
]
1

\
|
+ =
C. Wilsons Model of Adverse Selection in the Credit Market 5
2 / 7 > r : cannot be calculated
4
According to the assumption made above the total supply of
loans is:

>
<
|

\
|
+

|

\
|
+
=
2 / 7 for defined not
2 / 7 2 for
4
1
8
3
2 0 for
8
3
16
5
r
r r nB
r r nB
S
The loan market equilibrium could in general occur in both
ranges of the interest rate, i.e. ] 2 ; 0 [
e
r or ] 2 / 7 ; 2 ]
e
r . The
following calculation shows, that in this specific case the loan
market equilibrium occurs in the upper range, i.e. ] 2 / 7 ; 2 ]
e
r .
Condition for an equilibrium:
2 0 r :
5 . 4
48
216
8
3
16
5
2
= =

+ =
=
e
e
r
r nB nB
S D
This is clearly outside the given range, i.e. cannot be an
applicable solution.
2 / 7 2 < r :
2
5
4
1
8
3
=

+ =
=
e
e
r
r nB nB
S D
This lies within the given range and is therefore an equilibrium
rate of interest in this specific case. Note, that the equilibrium
interest rate is regarded as too high by low-risk borrowers who
would face an expected negative profit, i.e. an expected loss, of
B
B
B E
4
1
2
2 / 5
) ( = = .
C. Wilsons Model of Adverse Selection in the Credit Market 6
The loan demand of low-risk borrowers is therefore clearly
zero for 2 / 5 =
e
r . Only the high-risk borrowers demand funds.
They expect a profit of B
B
B E
4
1
4
2 / 5
8
7
) ( = = .
At the equilibrium interest rate banks expect a rate of return on
average of:
1
2
5
2 / 7 2 for
4
1
8
3
) (
=

< + =
E
r r r E
e
Is that the optimal, i.e. profit maximising rate of return for
banks? Hypothetically, assume that the interest rate is reduced by
1/2, i.e. 2 2 / 1 2 / 5 =
(5
. At this interest rate banks expect a rate
of return on average of:
16
17
) 2 (
2 0 for
8
3
16
5
) (
=
+ =
E
r r r E
e
h
This shows that the equilibrium interest rate ( 2 / 5 =
e
r ) is only
sub-optimal. Banks could raise their rate of return and in this case
profits
6
if they lower the interest rate.
The expected rate of return on the projects of each type of
borrower is:
low-risk borrowers: 4 / 5
2
5
2
1
0 *
2
1 1
) ( =

+ =
B
B
r E
high-risk borrowers: 4 / 5
1
5
4
1
0 *
4
3 1
) ( =

+ =
B
B
r E
This expected rate of return on the projects is distributed to
borrowers and banks in the following manner:
7
if 2 / 5 =
e
r :
4
1
1
4
5
borrower ror exp banks ror exp project ror exp
=
=
The roles of adverse selection and moral hazard in theories of credit rationing7
The expected rate of return of all projects is 5/4. Banks expect
a rate of return of 1, i.e. borrowers (note, these are only the
high-risk types) can only expect 1/4.
if 2 =
e
h
r :
16
3
16
17
4
5
borrower ror exp banks ror exp project ror exp
=
=
The expected rate of return of all projects is still 5/4. Banks
now expect a rate of return of 17/16. Therefore borrowers can
only expect a rate of return 3/16. Note that low-risk borrowers
will have a zero profit with an interest rate of 2, i.e. the banks
are better off at the expense of high-risk borrowers.
The conclusion of this model is that banks will ration credit to
increase their expected rate of return and their profits at the
expense of the high-risk borrowers.
2 The roles of adverse selection and moral hazard
in theories of credit rationing
Adverse selection arises from precontractual information
asymmetries (Milgrom, Roberts 1992, p. 149). A bank faces
adverse selection if the profitability of a loan depends on the type
of a borrower and if a higher price for a loan, i.e. a higher interest
rate,
8
not only attracts less borrowers but also attracts less
desirable borrowers. These are borrowers who invest in high-risk
projects and face a higher probability of default.
Efficient financial markets require higher rates of return for
riskier projects. But riskier projects also have a higher rate of
default, i.e. it is more likely that the borrower is not able to repay
a granted loan. If interest rates rise above a certain level it is
possible that low-risk borrowers, i.e. borrowers who face a lower
rate of return if the project returns its highest outcome, expect a
negative rate of return. Low-risk borrowers will therefore drop
out of the market. The number of high-risk borrowers to all
borrowers of a certain bank increases. Because high-risk
Why banks ration credit 8
borrowers are more likely to default the banks expected return
declines. In this case it is better for the bank to keep interest rates
low and thus ration credit.
Moral hazard is the ability of borrowers to take actions that are
not observable
9
to banks. Thus it is a form of post-contractual
opportunism (Milgrom, Roberts 1992. p. 167).
As argued before, if interest rates rises above a certain level
low-risk borrowers will drop out of the market because they face
negative expected returns. However, a borrower may have two
investment opportunities, a low-risk one and a high-risk one. An
investor who would undertake the low-risk investment if interest
rates are low enough may not drop out of the market if interest
rates rise but decide to undertake the high-risk investment.
Therefore, if banks raise interest rates above a certain level they
may face a lower rate of return because, although borrowers are
the same they are forced to undertake riskier investments.
3 Why banks ration credit
Credit rationing in its several forms is discussed in the
economic literature since the 1950s (Harris 1974). Exogenous and
endogenous factors lead to credit rationing.
Exogenous factors are mainly market imperfections. Interest
rates are not perfectly flexible in real life.
10
Interest rate changes
lead to a temporary disequilibrium due to a more or less short
transitional period. Local or federal government constraints on the
lending ability of banks are another example.
11
These forms of
credit constraints are discussed in the literature under credit
rationing. However, at least in the case of imperfect markets it
would only be a temporary phenomenon. Certainly, it only
describes disequilibrium credit rationing which in my opinion
occurs in financial markets but is not the intention of a particular
bank or group of banks.
The more interesting form of credit rationing is equilibrium
rationing, where the market had fully adjusted to all publicly, i.e.
Why banks ration credit 9
free, available information and where demand for loans for a
certain market interest rate is greater than supply.
Stiglitz and Weiss (1981) proved that credit rationing occurs if
banks charge the same interest rate to all borrowers, because they
cannot distinguish between borrowers and screening borrowers
perfectly is too expensive. Both assumptions are very simplifying
and do not occur in this manner in the real world. Banks are
usually able to distinguish their borrowers up to a certain degree.
Moreover, banks face more than only two types of borrowers.
Banks usually charge more than just one interest rate to all
customers. High-risk borrowers pay a higher interest rate and
credit rationing is less likely. However, I agree that banks cannot
distinguish borrowers perfectly
12
and screening them perfectly is
impossible
13
. Thus, credit rationing may occur.
According to Stiglitz and Weiss adverse selection and thus
credit rationing still occurs if banks require collateral. They argue
that low-risk borrowers expect a lower rate of return on average.
Thus, they are less wealthy than high-risk borrowers on average
after some periods. Low-risk borrowers are therefore not able to
provide more collateral. Increasing collateral requirements may
have the same adverse selection effect as a higher interest rate.
Instead Bester (1985) argues that banks only offer contracts in
which they simultaneously adjust interest rates and collateral
requirements. He proved that there is always a combination of
interest rate and collateral requirements so that credit rationing
does not occur.
14
This is true if banks require independent assets as collateral.
Very often the investment itself serves as a collateral
15
. In this
case it does not make any difference if the investor was a low-risk
type in the past or not. Nevertheless, I agree that collateral
requirements can cause adverse selection and therefore credit
rationing if the value of an investment itself which serves as a
collateral depends on the type of the borrower.
16
Conclusions 10
It is also often assumed that high-risk borrowers are only
concerned with the outcome if the project does not default. In
general this is not true in reality because if a project defaults it
generates costs to the investor. These may not be monetary costs
but the investor will loose his reputation or will go to prison. In
general a high-risk investor does not necessarily take less care
about a projects outcome.
17
4 Conclusions
In conclusion, there are some reasons why it is reasonable to
assume that banks ration credit in the real world. In general banks
cannot distinguish different risk types perfectly. They cannot
screen borrowers perfectly, not even if they do not care about
screening costs. They are in some situations not able to value
collateral independently from future returns which are uncertain
and depend on the risk of an investment.
For the above reasons I believe that banks ration credit in an
equilibrium to a certain degree (for early empirical studies see
Harris (1974)). However, I believe that there are less obvious
reasons for equilibrium credit rationing than some theoretical
models under simplifying assumptions imply. Moreover, I believe
that temporary credit rationing occurs due to market
imperfections.
References
Akerlof, George: The Market for Lemons: Quality Uncertainty and the
Market Mechanism. In: The Quarterly Journal of Economics, Volume 84
(1970), Issue 3, pp488-500.
Bank of England (editor): Monetary Policy in the United Kingdom. March
1999, http://www.bankofengland.co.uk/Links/setframe.html, viewed on
02
nd
Nov 2002.
Bester, Helmut: Screening vs. Rationing Credit Markets with Imperfect
Information. In: The American Economic Review. Volume 75 (1985), Issue
4, pp850-855.
Bierman, H. Scott; Fernandez, Louis: Game Theory. With Economic
Applications. New York (Addison-Wesley) 1998, Ch. 11 and 18.
Freimer, Marshall; Gordon, Myron J.: Why Bankers Ration Credit. In: The
Quarterly Journal of Economics. Volume 79 (1965), Issue 3, pp397-416.
Goodhart, C.A.E.: Money, Information and Uncertainty. London (Macmillan
Press) 1989, Ch. 7.
Notes 11
Harris, Duane G.: Credit Rationing at Commercial Banks. Some Empirical
Evidence. In: Journal of Money, Credit and Banking. Volume 6 (1974),
Issue 2, pp227-240.
Milgrom, Paul; Roberts, John: Economics, Organziation and Management.
London (Prentice-Hall) 1992.
Stiglitz, Joseph E.; Weiss, Andrew: Credit Rationing in Markets with Imperfect
Information. In: The American Economic Review. Volume 71 (1981), Issue
3, pp393-410.
Wilson, Charles: The nature of equilibrium in markets with adverse selection.
In: Bell Journal of Economics. Volume 11 (1980), pp108-130.
Notes
1
The model is presented with specific numbers. It can therefore only deliver
one example for credit rationing. For a proof of the existence of credit rationing
under certain circumstances it has to be generalised which is not the aim of this
essay.
2
The following model is based on C. Wilsons model of adverse selection
published 1980 (Wilson 1980). Wilson applied his model originally to the
market for lemons following George Akerlof (Akerlof 1970).
3
Note, it is assumed that the interest rate on loans is always non negative, i.e.
possible demand for a negative interest rate is not mentioned.
4
Note, the expected (gross) rate of return of the banks is mathematically not
defined in this range of the interest rate. Demand for loans is zero, i.e. the rate
of return is divided by zero which is not defined.
5
This interest rate is symbolised by
e
h
r (hypothetical equilibrium interest rate).
This is because it is neither an equilibrium interest rate nor an hypothetical
interest rate. It will turn out that banks are better off with this lower interest
rate, i.e. they will ration credit according to this model.
6
Generally, an increasing rate of return does not necessarily mean that profits
will increase. Profits are defined as the difference between return and costs.
The model does not assume any specific costs but a possible repayment lower
than B if the borrower defaults. If as assumed hypothetically the interest rate
would be 2 then the possible rate of default decreases because the low-risk
borrowers have a demand for loans greater than zero. On average the banks
costs in terms of repayments forgone are lower then and the profit must be
higher.
7
In the following: ror:= rate of return.
8
Assume that the interest rate is the only price for a loan, i.e. it includes a usual
interest rate and several possible fees which are often claimed in the banking
business. This includes organisation or up-front fees, commitment fees etc.
9
Actions may be observable but at least not freely. If a bank could observe all
actions a borrower may take perfectly without costs, moral hazard would not
occur.
10
Possible reasons for short term sticky interest rates are for example contract
duration and time lags. An investor may want to demand a higher quantity of
loans for a lower interest rate but cannot leave the existing contract for the
former higher interest rate without paying a penalty. If the central bank decides
to lower interest rates commercial banks often follow this decision by lowering
their own rates only with a time lag.
11
One main constraint exists since 1988. The Basel Committee, founded by the
presidents of the central banks of the G10-Countries, released its equity
regulations so-called BASEL I. Under these regulations banks are allowed to
grant credit only up to the 12.5-fold of their equity, i.e. every credit is to be
underlaid with 8% of equity. BASEL I is currently under review, a draft of the
new regulations called BASEL II is already released and widely discussed. It
will probably become effective by 2006.
Notes 12
An earlier example for a government constraint is the CORSET in the UK
which came into force in 1973. It controlled the growth of interest-bearing
deposits and thus indirectly the quantity of credit (Bank of England 1999).
12
To distinguish borrowers in the corporate department is possible up to a
certain degree. Banks require annual reports, profit and cash-flow statements,
profit and cash-flow forecasts for the whole corporation and for certain
projects. Moreover, banks have in general a closer customer relation with
corporate clients. Strategic talks are held regularly during the year, i.e. the bank
is more informed about current and future actions the customer is to undertake.
However, controlling the customer is necessary but by far not perfect. Business
and investment forecasts are uncertain and very often banks have to rely on
information which the customer gives them, i.e. on the customers honesty.
13
Even if a bank do not care about the costs of screening, a customer cannot be
screened perfectly. This would mean for the bank to make the business itself.
Otherwise there is always the chance that the customer is not telling the truth,
that he is hiding some information, is altering figures etc. Perfect screening is
not possible.
14
Note, that Bester assumed that any collateral can be provided without costs.
However, this is not always the case. In the Stiglitz and Weiss example where
an independent deposit serves as a collateral it causes costs in the form of
opportunity costs. If an investment itself, as I will argue in the next paragraph,
serves as a collateral one could argue that it can be provided without costs. In
spite of low administrative costs a transfer by security or a mortgage does not
generate any opportunity cost.
15
In the case of an investment in a house, ship or aircraft it is very common to
use the investment itself as a collateral (mortgage). But also in the case of
industrial investment like machines etc. the investment itself is often the
collateral by a transfer of security.
16
An industrial investment, e.g. a machine, often has a special construction for
a certain project and could be worthless if the whole project fails. In this case
the value of the machine may depreciate to just its metal value. High-risk
borrowers may tend to overestimate the future outcome and thus the machines
value. If banks have to rely on customer information, i.e. if they cannot value
the machine independently, they could be worse off if they were increase their
collateral requirements.
17
Note, that this assumption may be true for some mid-sized corporations.
Managers who decide to undertake an investment in these firms are often
employees who do not hold any shares in the company. However, if the
company fails and the managers are replaced they often get a large lump-sum
compensation (sometimes called a golden handshake). It is reasonable to
assume that those kinds of managers are less interested in the outcome of the
project if the company fails, i.e. they are less risk-averse or may be risk-lovers.
But note also, that this does not necessarily apply to very big corporations
because very often a part of the salary of board members is paid with stock
options or stocks themselves. In this case the manager is both an employee and
a shareholder and has an interest in any investments outcome.