Pessimism, Optimism and Credit Rationing

In their celebrated contribution on credit rationing, Stiglitz and Weiss (1981) showed that the expected return to the borrower on a loan is increasing in the risk of the project it funds. In this paper, I show that their results do not necessarily carry over to the case where the agents’ preferences can be described by rank-dependent expected utility (RDEU). In particular, a pessimistic probability distortion function for borrowers can yield sufficient concavity in returns for the latter to be decreasing in risk, thus eliminating adverse selection. Whether credit rationing can obtain or not is then shown to depend upon the interaction between borrower pessimism and lender optimism.