Credit Rationing - Equilibrium Credit Rationing - Stiglitz and Weiss - Redlining

Redlining

Redlining is a different situation, as it is not the result of adverse selection. In fact, the bank can perfectly distinguish between the different types of buyers according to some criterion. Each type is assumed to have a different expected return function (from the point of view of the bank).

As an illustration, consider the case of three types, 1, 2 and 3, which are ranked according to the maximum expected return they give to the bank, from lowest to highest. The maximum expected return a type 3 borrower can give to the bank (at the optimal interest rate for the borrower) is higher than that of type 2, which is higher than that of type 1.

For a sufficiently high cost of obtaining funds, only type 3 borrowers will receive credit. This will occur if the maximum expected return from type 2 borrowers is lower than that cost. If costs fall by enough, type 2 borrowers will obtain credit, and if they fall further so will type 1 borrowers. Every type that receives credit will be charged different interest rates, but the expected return to the bank will be equal for each type, as long as there is competition between banks.

It is important to note that type 1 borrowers obtain credit only if type 2 borrowers are not rationed, and so on.

This argument is quite pertinent in the context of the subprime mortgage crisis. Low interest rate setting by the Federal Reserve made the cost of loanable funds extremely low. On the other hand, the securitization practices of firms in the credit markets significantly raised the profitability of loans to people with poor credit ratings (type 1 in the example above), and thus contributed to massive leveraging of borrowers who would ordinarily have had a hard time receiving even modest loans.

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