Credit Rationing Essay Example | Topics and Well Written Essays - 1000 words

Credit Rationing - Essay Example The extent of this level depends entirely on the perceived risks in the bank's lending or investment activities. This limitation sometimes leads to credit rationing, which is a situation where a bank refuses credit to a borrower at an interest rate set by the bank itself, because of unavailability of sufficient free capital. To understand the pressures on the capital free for lending available to the bank, we need to understand the limitations placed on it by the central bank in the particular country in order to control its activities. One of the limitations on the bank is the statutory requirement that it should submit a defined percentage of certain kinds of the deposits it receives, into the central bank as reserves at zero interest, in vault cash or deposits. These requirements represent a cost to the bank, as they earn no revenue,and are not in the bank's control.These reserves are used in the day-to-day implementation of monetary policy by the Central Bank. The percentage deduction from each deposit may go towards the maintenance of the entire banking system, but it reduces the amount of capital left to the bank for lending or investments. Another requirement is for the bank to maintain an amount of liquid assets for itself as reserve against specified deposit liabilities, for instance, to pay depositors in case they wish to make a withdrawal, or a certain amount that is due to them at the expiration of a designated saving activity. This further reduces the balance capital for investments, and these liquid assets languish in the bank without working to earn an interest. Higher the statutory reserve and liquid asset requirements, lower the amount of cash available to the bank to extend in terms of credit. In some countries, the statutory reserve ratio is high, resulting in less available amount of credit given out to the borrowers.Thus rationing the credit is the only option left to the bank, in order to maintain the capital adequacy requirements. In the periods where the demand for credit is high, because of a booming market or low interest rates, it may be suggested that the bank increase its interest rates, instead of rationing credits at previous rates. But this could result in bad credit, because the creditworthy individuals move off to cheaper options, following the conditions of adverse selection and the borrowers willing to pay the high rates are those who have very little to lose, or are willing to give up their collateral in exchange for the loan amount. In this case, the bank may be also stepping into a situation of moral hazard where the motives of these borrowers are suspect. To avoid these, banks try to give loans at affordable interests to those with a perceived low credit risk and ration it in the case of all others. But this does not always protect them from acquiring bad loans, or non-performing assets. An asset or loan becomes 'non-performing' or bad when it has not been serviced, or in other words, the interest and/or instalment of principal has remained 'past due' or unpaid for more than the stipulated period, 90