Adverse selection as an explanation of credit rationing and different lender types

An adverse selection model is utilized to demonstrate that informational asymmetry may make it wealth optimal for the financial intermediary (FI) to credit ration and to rationalize the existence of different lenders in the credit market. The crucial assumption is that borrowers differ in their tolerance for a lender-imposed default penalty, the severity of which also varies with the lender. The credit rationing portion proves that the FI will: 1) be forced by a binding regulatory constraint to overinvest in capital; 2) ration its worst risk class borrowers; 3) establish its optimal loan interest rate on the basis of the average quality of its loans and the interest rate elasticity of the borrower demand in its best risk category; and 4) decrease the total loan volume and increase the loan interest rate due to an increase in the capital requirement, but the effect on the default risk quality of its loan portfolio is ambiguous. The existence result is that if a lender has a high default penalty, he can charge a lower rate and attract only “good” borrowers, i.e., heterogeneous lender types encourage the screening of borrowers and vice versa.