Financial Liberalization and Intervention
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Financial Liberalization and Intervention

A New Analysis of Credit Rationing

  • New Directions in Modern Economics series

Santonu Basu

This book seeks to provide a coherent explanation as to why the policies of financial liberalization and financial intervention have been unable to achieve the goal of improving the access of borrowers to the loan market, irrespective of size. This is one of the prime criteria for achieving efficiency in the operation of the loan market and its failure has resulted in increased uncertainty and financial fragility.
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Chapter 3: The Theory of Credit Rationing Revisited

Santonu Basu

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3. The theory of credit rationing revisited 3.1 INTRODUCTION The issue of credit rationing principally arises when two individuals are prepared to pay the price, and one receives the loan, while the other is either denied the loan altogether or receives less than he or she demanded. The question is, why is this so? In other words, why do two individuals have different degrees of access to the loan market? It is argued in this chapter that bankers operate in the presence of uncertainty, and as a result cannot calculate in advance the precise magnitude of the probability of borrowers returning the loan (i.e. principal plus interest rate). In other words, they cannot calculate the precise magnitude of default risk on an a priori basis. Consequently, bankers employ credit standards as an alternative means to recoup the loan, should the borrower’s project fail. The credit standard (which includes some form of security or collateral) therefore is an attempt to insure banks’ loan capital against uncertain outcomes. When loan applicants do not meet banks’ credit standards, their applications will generally be rejected. In fact, most failed credit applicants are those who do not meet banks’ credit standards. This is because the banker knows that in the event of a borrower’s failure to maintain the repayment rate, it is the bank that has to bear the major cost. Thus these borrowers are not profitable in the bank’s eyes. However, the credit standard that banks set is not determined entirely by bankers’ wish...

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