In their 1981 paper, “Credit Rationing in Markets with Imperfect Information”, Joseph E. Stiglitz and Andrew Weiss define a situation similar to the case of The Market for Lemons, an article by George Akerlof, except in the financial markets. In this case, it is the ‘seller’ of credit who pulls out of the market because of adverse selection.
Credit rationing implies that credit is not available for all those who want it, at any interest rate. If markets worked perfectly, supply and demand for credit would fix a level of interest rates at which lenders would be happy to assume the risk, and borrowers would be happy to accept it in order to fund their projects. However, accepting high interests can also be a signal: if we have a good credit rating and are not desperately in need of funds, we probably won’t accept excessively high interest rates, we will simply put off our projects or purchases. Really needing money is intrinsically a bad sign for lenders, which can mean that when interest rates rise above a certain level, financial agents can assume that you are a ‘lemon’, and that the risk of you defaulting on your credit is too high. The chances are you are either acquiring the loan in good will but in dire financial straits (which means that despite your best efforts you’ll probably default anyway) or that you simply don’t care about the interest rate you are charged because you have no intention of paying the loan back in the first place.
Supposing there are two types of borrowers, As and Bs, who both want to invest in similar projects with a different level of risk, and assuming that As invest in ‘safer’ projects than Bs although the mean return is the same, say 110. As have a range of possible ROIs, ranging between 90 and 120 for their investment, meaning that if they invest 100, then for interest rates over 20% their profit will be 0 even if their project is successful. However, Bs also have a mean return of 110 for their 100 invested, but with a range of between 70 and 180, with a distribution that skews their average ROI to 10%, just like the As. This means that, if they are really optimistic (as riskier investors tend to be), they can potentially accept interest rates of up to 80% and still break even.
Assuming both As and Bs default on their credit if their ROI is negative (below 100), which is an assumption that banks are fond of making, then they will have a natural cut off point, assuming that all those willing to accept rates of over 20% are therefore risky investors, Bs. When interest rates approach 20%, credit will simply dry up as all those willing to accept higher rates and still borrow will be singled out as probable defaulters.