Asymmetric Information in Banking

In this chapter, we analyze the information asymmetries in the bank–firm relationship related to the lending function. Information asymmetries may lead to banking market failures, like, for example, credit rationing, in particular during periods of economic downturn. Credit rationing occurs when the demand for credit exceeds supply; i.e., whenever the price of credit is lower than equilibrium. We investigate why banks prefer rationing some of their customers instead of increasing interest rates on loans to bring the market into equilibrium (as suggested by neoclassical price theory). Traditionally, credit rationing represents for firms both a problem of obtaining loans and bearing their costs, and thus, it affects both the trend of loans’ interest rates and the quantity of loans granted and utilized, producing a certain rigidity in both loans’ quantities and prices. In particular, the loan risk premium (i.e., the difference between the loans’ interest rates and the risk-free rate) negatively correlates with market interest rates. The rigidity in interest rates implies that banks prefer not to increase the interest rate beyond a certain threshold to limit the potential risks of adverse selection and moral hazard. Several empirical studies suggest that credit rationing is widespread among start-ups, small and young companies and firms investing in Research and Development (R&D). Furthermore, financial constraints become increasingly important during economic crises like those characterizing the last decade.