Rationing in a Theory of the Banking Firm

109 Pages·1986·3.247 MB·English

by  Timothy M. Devinney (auth.)

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Studies in
Contemporary Economics
Timothy M. Devinney
Rationing in a Theory
of the Banking Firm
Springer-Verlag
Berlin Heidelberg New York Tokyo
Editorial Board
D. Bos G. Bambach B. Gahlen K. W. Rothschild
Author
Timothy M. Devinney
Assistant Professor of Management
Owen Graduate School of Management
Vanderbilt University
Nashville, TN 37203, USA
ISBN-13:978-3-540-16052-6 e-ISBN-13:978-3-642-82649-8
001: 10.1007/978-3-642-82649-8
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© by Springer-Verlag Berlin Heidelberg 1986
2142/3140-543210
ACKNOWLEDGEMENTS
The present paper represents a variant of Chapter one of my
doctoral dissertation at the Graduate School of Business, Uni versity
of Chicago. I would like to acknowledge the aid received from my
thesis committee John Gould, Albert Madansky, Dennis Carlton,
Douglas Diamond, Merton Miller, and Edward Lazear. The comments of
Ernst Bal t ens per ger , Mark Flannery, Dwi ght Jaffee, Hans Stoll,
Hellmuth Milde, Timothy Thompson, and Werner Rothengatter, along with
the participants of workshops at the University of Chicago, University
of British Columbia, Vanderbilt University, ESSEC, INSEAD, the
University of Brussels, London Business School, Universitat Karlsruhe,
Universitat Konstanz, and Universitiit Ulm are gratefully
acknowledged. The typing skills of Ms. Maureen Writesman and the
graphical work of Mr. Danny Sulkin were indispensible. Finally, I
leave my greatest appreciation to Sandra Brandt for putting up with
all the trials and tribulations of life with an academic.
Research support was received from the Center for the Management
of Public and Nonprofit Enterprise at the Graduate School of Business,
University of Chicago, and the Dean's Fund for Faculty Research, Owen
Graduate School of Management, Vanderbilt University.
TABLE OF CONTENTS
ACKNOWLEDGEMENTS
CHAPTER 1 SUMMARY 1
CHAPTER 2 BACKGROUND AND LITERATURE REVIEW 3
2.1 THE AVAILABILITY DOCTRINE 4
2.2 THE EARLY THEORY 4
2.3 INFORMATION-BASED THEORIES 6
2.4 SUMMARY OF CREDIT RATIONING THEORY 8
CHAPTER 3 A THEORY OF CREDIT RATIONING 10
3.1 A MODEL OF BANK OPERATION AND LOAN SUPPLY 10
3.1.1 SCREENING TECHNOLOGY 15
3.1.2 COLLECTION TECHNOLOGY 19
3.1.3 DETERMINATION OF THE BASE DEFAULT
PROBABILITY 23
3.1.4 BANK PROFIT FUNCTION 25
3.1.5 LENDER CONTRACT OFFERS 27
3.1.6 SUMMARY OF THE BANK MODEL 28
3.2 A MODEL OF BORROWER BEHAVIOR 28
3.2.1 THE DEFAULT/NON DEFAULT CHOICE 33
3.2.2 SUMMARY OF THE BORROWER MODEL 35
3.3 EQUILIBRIUM IN THE LOAN MARKET 35
3.3.1 A SINGLE CONTRACT POOLING EQUILIBRIUM 35
II II
3.3.2 A MULTIPLE-CONTRACT EQUILIBRIUM 42
3.3.3 SUMMARY OF THE LOAN MARKET EQUILIBRIUM 43
VI
3.4 THE ROLE OF COLLATERAL IN A LOAN CONTRACT 44
3.4.1 LENDER OPERATIONS WITH COLLATERAL 45
3.4.2 BORROWER BEHAVIOR WITH COLLATERAL 48
3.4.3 COLLATERAL AS A SIGNAL 52
3.4.4 EQUILIBRIUM WITH COLLATERAL 55
3.4.5 SUMMARY OF THE ROLE OF COLLATERAL 56
3.5 SCREENING AS A SIGNAL 57
3.6 SUMMARY OF THE THEORY OF CREDIT RATIONING 61
CHAPTER 4 CUSTOMER RELATIONS 64
4.1 BACKGROUND ON CUSTOMER RELATIONS MODELS 64
4.2 A MULTI-PERIOD MODEL 68
4.3 A MULTI-PERIOD MODEL WITH CHANGING INFORMATION 76
4.4 SUMMARY OF CUSTOMER RELATIONS 79
CHAPTER 5 CONCLUSIONS AND IMPLICATIONS 81
5.1 RATIONING IN A GENERAL EQUILIBRIUM FRAMEWORK 81
5.2 REGULATORY IMPLICATIONS 84
5.3 MONETARY POLICY IMPLICATIONS 87
5.4 SUMMARY 89
ApPENDIX 91
REFERENCES 96
CHAPTER 1
SUMMARY
The existence of non-price rationing in credit markets is a
subj ect, not only of paramount importance, but of considerable
controversy, which is ultimately linked with our understanding, or
lack thereof, of the basic nature of the banking firm. A recognition
of this phenomenon is critical to the understanding of the banking
firm in its major role as a financial intermediary. The banking firm
serves as an intermediary in two important spheres, between borrower
and lender, and between spenders and the monetary authorities. The
basic economic formulation of borrower-lender behavior, the simple
Fisherian consumption loan model, while beautiful in its simplicity,
fail s to acknowledge any role for a non-neutral financial
intermediary. The bank, in its second intermediary role, leads one to
question the assumption of both neoclassical and Keynsian monetary
theories that monetary changes are diffused across the economy (the
proverbial monetary helicopter). Monetary policy effects on spending
and investment will clearly be biased by the policies of the banks.
The major focus of the present work is the development of a
theory of credit rationing based upon the existence of risk reducing
information technologies. Implicit in the analysis is a discussion of
the role of the banking firm as something more than a tr·aditional
financial intermediary. The present analysis will focus on the bank
as an intermediary between borrower and lender. It will be shown that
in . this capacity the bank's major role is one of information
analyzer. The bank is shown to be much more than a neutral broker.
Given this framework, rationing is not so much the result of risk per
se but rather the bank's ability to recognize and react to that risk.
In Chapter 2 a discussion of prior credit rationing theories is
given. The discussion is both brief and non-technical and is provided
to give the reader a better understanding of the motivation behind the
present theory. Earlier surveys by Baltensperger [1978J and Koskela
[1983] along with a more recent paper by Baltensperger and Devinney
[1985] provi de a much more techni cally complete survey of pri or
theory.
In Chapter 3 a model of credit rationing as a function of an
information technology is developed. This model discusses the
2
differential value of penalties and collateral and their weakness as
mechanisms for separating good from bad risks. The information
technology can be shown to resolve many of the instability problems
found in separating and signalling models.
In Chapter 4 an examination of long-term bank-customer relations
is given. After a brief survey of prior research, an elaboration of
the informational value of long term relations is given. Unlike other
models, it is shown that while not causing rationing, long-term
relations can have an impact on the degree of the phenomenon.
Finally, Chapter 5 presents some concluding statements, discusses
the implications of the model, and addresses possible future issues.
The implications of various types of regulatory intervention are
discussed along with the monetary distortions caused by a non-neutral
financial intermediary. An extended bibliography is provided for
those wishing to examine the literature in this and related areas.
CHAPTER 2
BACKGROUND AND LITERATURE REVIEW
Why banks would ration credit through non-price means has been an
unresolved issue for more than five decades. Keynes [1930J noted that
"there is apt to be an unsatisfied fringe of borrowers, the size of
which can be expanded or contracted, so that banks can influence the
volume of investment by expanding or contracting the volume of their
loans, without there being necessarily any change in the level of
[theJ bank-rate." This simple statement pointed to three major
questions. First, why would banks choose to alter quantity and not
allow price to do the rationing? Second, given the choice of quantity
adjustment, how is the shortage allocated? Economists typically
assume that the allocation is random across identical individuals;
yet, in reality, the allocation is neither random nor are the
individuals identical. Third, how does rationing affect the role of
the banking firm as a financial intermediary? Why, when an excess
demand for loans exists, should the bank not attempt to attract more
funds through the raising of the deposit rate; or, from a monetary
perspective, why should the banks not fully accommodate any increase
in redit made available by the monetary authorities?
Keynes' attack was aimed at the assumption of the qui ck
equilibriation of credit markets made by classical monetary theory.
It was, in many ways, the predecessor of similar arguments with
respect to prices and wages to be found in The General Theory five
years later. Two issues arose around the issue of the equilibriation
of the aggregate loan market. The first issue was not whether some
credit rationing existed but what it was a response to; that is, was
non-price rationing a temporary disequiiibrium phenomenon or was it of
a more permanent equilibrium nature? While the subject received a
considerable amount of debate, it is clear from the accumulated
evidence of both time and related markets (labor, for example) that
the portion of credit rationing which is of a temporary disequilibrium
nature is small. The issue then becomes whether the permanent credit
rationing evidenced is a permanent disequilibrium phenomenon or truly
consistent with unconstrained profit maximization by banks; i.e., a
permanent equilibrium phenomenon.
Keynes di d not provi de ready answers to any of these questi ons.
4
As will be shown, the older theory, most notably the availability
doctrine, concentrated on institutional and monetary policy issues
without ever clearly developing a rationale for why credit rationing
would be expected to occur. It was soon realized that the larger
issues could not be addressed until an understanding of the simple
question of why rationing occurs was found. Since 1960 economists
have concentrated on understanding this more basic issue.
2.1 THE AVAILABILITY DOCTRINE
The availability doctrine of the 1950's (see e.g., Roosa [1951],
Scott [1957a,b]; Lindbeck [1962]) arose as a monetarist (central bank)
response to the apparent interest rate inelasticity of aggregate loan
demand. It was, in most respects, an argument for credit rationing as
a permanent disequilibrium phenomenon derived from certain specific
institutional constraints. Unfortunately, the availability doctrine
was less a theory than ad hoc speculation. Relying upon a mix of
governmental constraints, such as interest rate ceil ings, and
institutional assumptions, such as "security-minded" investors and
minimum bank liquidity requirements, it attempted to rationalize a
,permanent rigidity in the aggregate loan rate. The availability
doctrine suffered from the major weakness of most disequilibrium
theories, the validity of its assumptions. It lacked a solid
theoretical foundation upon which empirically testable hypotheses
could be built and its assumptions validated. Exactly why one should
believe in the rationality of "security-minded" investors, for
example, was never proven. However, while it did not answer any of
the questions critical to the credit rationing debate, it brought to
the forefront two pOints which have remained at the basis of
problem. First, it focused attention on the role of the bank as
intermediary. Second, it distinguished between a pure commodity price
and the loan interest rate. The loan interest rate was finally
recognized as something more than simply a homogeneous commodity
pr i ce .
2.2 THE EARLY THEORY
With the demise of the availability doctrine there was an
implicit recognition that the issue of permanent credit rationing was
truly an equilibrium phenomenon and could not be adequately addressed