Credit Rationing by Loan Size: A Synthesized Model
23 Pages Posted: 30 Jan 2012 Last revised: 22 Dec 2015
Date Written: February 1, 2015
We construct a synthesized model to study credit rationing by loan size. In our model, the borrower faces a trade-off between raising debt and exerting costly effort to undertake an investment project. In the absence of agency costs, increasing the loan size at the equilibrium interest rate raises the default risk and hence reduces the average cost of the loan for the borrower, so the borrower always demands a larger loan than what the lender can offer. Furthermore, agency cost raises this excess demand for a given interest rate. If the agency cost is sufficiently high, the borrower is unable to obtain the loan that she needs at any interest rate, requiring the use of non-price instruments in the loan contract. This is the common logic underlying the agency models of non-price credit rationing, as we show in the cases of costly state verification, money diversion, risk-shifting and hidden shirking.
Keywords: credit market, debt, credit rationing, agency cost, hidden effort, moral hazard, money diversion, costly state verification, monitoring cost
JEL Classification: D82, D86, G21, G32
Suggested Citation: Suggested Citation