Credit market is characteristically different from the conventional auction market where sellers can freely adjust prices in response to demand and supply. In credit market, the law of demand is not fully applicable; the higher demand for funds doesn't necessarily imply higher interest rate. In fact, higher demand accompanies lower interest rate - an interest rate that is fixed at a reasonable level so that return is maximised. In this sense, excess demand function is not continuous. This simple rule escaped the notice of both academicians and bankers until Stiglitz and Weiss and others propounded the well-known credit rationing hypothesis.
Even then, the level of awareness about credit market and its characteristic operational rules and regulations are still at infancy. Especially bankers follow the conventional loanable fund theory which says that higher demand for loanable funds means higher interest rate; that means we have exactly fully continuous excess demand function which says that price adjusts freely to clear markets.
As far as clearing of market is concerned, credit market equilibrium is not like the conventional market equilibrium in which demand must equal supply. Instead, equilibrium in credit market means setting an interest rate that maximises returns for banks and minimises risks for borrowers. In this equilibrium notion, equalisation of demand for and supply of funds are almost irrelevant and not necessary at all. That means there can be excess demand for funds, and credit market is at full equilibrium. Understanding the nature of the equilibrium of credit market is very crucial because on this rests the proper functioning of the credit market.
The lesson is very simple and easy to grasp. Bankers need to be careful about setting lending rate. The conventional loanable fund theory dictates that banks should watch over demand and supply conditions and adjust interest rate accordingly. But lending is not the end; returns of banks are dependent on to what extent they can recover interest rate plus the principal. If they lose both interest and principal, then returns from lending will turn out to be negative.
Credit rationing hypothesis offers a very catching solution to this problem. The solution is that banks should set interest rate at a level and should not lend below and above that interest rate. If banks raise interest rate above that level, bad borrowers will crowd the market bidding higher interest rate. That means lending at higher interest means earning negative returns since these borrowers are the potential defaulters. They are most likely to default because to pay higher interest rate they have to undertake some projects that offer higher returns. But projects with higher returns are the risky projects. Banks should lend below that interest rate because lending below that rate doesn't increase returns of banks; in fact lending above that rate will increase returns of banks.
We have a point here. Lending above the fixed interest rate decreases returns and lending below that rate do not increase returns. So, lending at the fixed rate will maximise returns for banks. This is the essence of the credit rationing hypothesis. As for the relevance and application, banks and financial institutions can adopt this method.
Currently, our banks are facing excess liquidity problem. But excess liquidity doesn't mean that banks should decrease interest rate to create the demand for funds. As said, excess demand function of the credit market doesn't obey the conventional rule- higher demand the higher price and lower demand the lower price.
Since credit market equilibrium is obtained at a point where returns of lenders are maximised and risks of borrowers are minimised, excess liquidity should not necessarily accompany a lower interest rate in our country. Interest rate will naturally come down if suitable conditions prevail. Any kind of forcible reduction will ultimately prove to be futile.
Instead, attention should be given to the proper corner. Banks should be urged to introduce a practice of advancing credit to good borrowers at the credit rationed rate - a rate at which banks' expected returns are maximised. Banks should shun the conventional loanable fund theory since this model offers a deceptive picture of the nature of the credit market. Adoption of credit rationing technique will help banks to reduce the interest rate spread too.
Lending at credit rationed rate means banks will not lend to likely defaulters. This in turn will decrease lending risk of banks; that means banks will lend at a rate that will be much lower than the rate that banks currently charge borrowers. Such a reduction of the lending rate will hardly affect the deposit rate since credit rationing rate is the return maximising rate for banks. Decrease of lending rate without any change in the deposit rate means a decrease in the interest rate spread.
The thing that is required for a sound credit market is the correct understanding of the nature of equilibrium of the credit market and how it is reached. This kind of knowledge is sorely needed to build a strong credit market.
The writer is Faculty Member, the School of Business, North South University.
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