Competition, Collateral, and Sorting Equilibria in the Credit Market

Lenders usually know less than borrowers about payoff-relevant borrower attributes. These attributes may be a personal characteristic as in Jaffee-Russell [1976] or some parameter of an earnings distribution as in Stiglitz-Weiss (S-W) [1981]. In either case, the informational asymmetry is likely to affect the credit market equilibrium. The principal objective of this paper is to explore the role of market structure in credit allocation when there is such an informational asymmetry. The questions to which we seek answers are: Why do lenders sometimes ration credit even when deposit availability is relatively unconstrained? What is the economic function of collateral and how is its usefulness affected by credit market structure? What is the impact of collateral on credit rationing? Why do we observe cosigners? These issues are analyzed under two market structures. In Section 2, we assume that a bank acts as a price-setting monopolist in the loan market. Two principal results are obtained. First, collateral will not be used unless it is sufficiently valuable to the bank to make the loan riskless. Second, in some cases, the bank's credit policy discourages high-risk borrowers from applying for credit. The bank need not explicitly reject these applicants; it simply raises the loan interest rate to induce them to exit the market.