Risky Banking and Credit Rationing

In this paper a bank faces excess demand in the loan market, can sort loan applicants by an observable measure of quality, and faces a small but positive probability of default. The bank uses two policies to allocate credit: (i) tighten restrictions on loan quality; (ii) limit the number of loans of a given quality. We show that the level of default risk and other structural conditions have important effects on the market for loanable funds and the bank’s optimal policies (loan rates, deposit rates, and lending standards). The structural conditions that we examine are monitoring costs, returns on alternative investments, firms’ minimum funding requirements, and the level of the reserve requirement. The model provides insight into several stylized facts observed in loan markets, especially in developing countries.