LAW - LEGAL ISSUES

Credit Rationing



Credit Rationing

Credit Rationing

When banks increase the interest rate on loan lending in response to excess demand, potential borrowers are not credible enough to assure low risk and thus, lower the quality of loan. Credit rationing is the most effective instrument that many international banks use in their operations through which they can manage the quality of loans by lowering the interest rate below the market rate in order to ensure safe borrowing and approach credible customers (Ghosh et al., 2000, pp. 2-8). Credit rationing implies the existence of excess demand at the prevailing price. As defined by that excess demand, we can find different types of rationing:

1) Rationing price (or interest rate): the borrower receives the amount at the current interest rate because the risk increases with the size of the loan.

2) Rationing by divergent views: the borrower receives credit interest rate do appropriate, given their perception of what their level of risk, because their assessment of the probability of default is different from the one with the lender.

3) Pure Rationing: the borrower receives no credit, current interest rate, and while if they receive other borrowers who apparently have the same level of risk.

4) Exclusion: given the risk rating of a debtor, the creditor is not willing to lend to any interest (Jaffee and Russell, 2002, pp. 651-666).

Irresponsible Borrowing

Potential borrowers who have been rejected can not borrow, even if they indicate their willingness to pay more than the market rate of interest. In this context, the interest rate that an individual is willing to pay as a means of discrimination because only firms with high-risk project are willing to borrow in such conditions (Ghosh et al., 2000, pp. 2-8). Therefore, the increase in interest rates may increase the risk of the loan portfolio of the bank, causing a degradation of the quality and therefore the profitability of bank assets, to the extent that it results in an increase in proportion of bad borrowers, or if it encourages the development of riskier projects (which have also a probability of success smaller but higher returns in case of success).

Thus, a single interest rate can not balance the credit market. If it is too low, the profitability of lending is not insured, it is too high the least risky projects will be deterred. The balance will be done by quantities. Borrowers who seem most at risk are rationed. In these circumstances, credit restrictions take the form of limiting the number of loans and not a limitation of the size of each loan or limitation by the rate of interest paid by the latter to depend the amplitude of the loan. The assessment made by the banker would not be as close as the desirability of individual pricing of credit risk (www.saylor.org, 2012, pp. 1-3).

It is interesting to note here that, when it is not possible to assess the probability of failure associated with credit applications for potential borrowers, the bank risk by increasing its ...