Loan Size and Credit Rationing Under Asymmetric Information

In this paper we analyze the effects of adverse selection due to asymmetric information on the optimizing behavior of risk neutral firms and banks in a competitive loan market. Realized film returns have the monotone likelihood ratio property (MLRP) with respect to quality, in the sense of Milgrom (1981). This property encompasses the assumptions which characterize previous models such as Stiglitz and Weiss (1981) and De Meza and Webb (1987), allowing for a more general framework. Moreover, similary to Milde and Riley (1988), the present model has loans of variable size, as opposed to the fixed loan size of Stiglitz and Weiss and De Meza and Webb. The references to a parameter of organizational complexity of the firm, defined by the prevailing type of economies of scale and costs, and to a Wilson (1977) construction of the contracting game, whereby uninformed lenders move first in a three-stage pure strategy game, differentiate the present model from Milde and Riley's with respect to two main elements: (i) while Milde and Riley's model is based on three different and unrelated cases, our model is able to subsume the various cases within a unified framework; (ii) while Milde and Riley's assumptions rule out the possibility of pooling equilibria, the Wilson construction in our model entails the possibility of both separating and pooling equilibria. In particular, pooling equilibria obtain whenever applicants of different quality have indifference curves so similar that banks are unable to screen out their projects. This result strengthens the possibility of credit rationing even in the presence of signaling through the size of the loan. Both separating and pooling equilibria entail the possibility of type I credit rationing of given quality types.