Research library Adverse selection
Why Banks Say No Instead of Charging More.
Stiglitz and Weiss showed that raising the price of a loan changes who applies and how they behave. Past a point, a higher rate makes the whole book riskier.
Joseph E. Stiglitz and Andrew Weiss, 1981
The bank's expected return as it raises the interest rate
What they were looking at
Bank lending. A lender can screen applications, but it still can’t fully see how risky each borrower is. Textbook economics says that when there are more borrowers than money to lend, the price of money (the interest rate) rises until the market clears.
Stiglitz and Weiss pointed out that raising the rate has two side effects. An “adverse selection effect”: it changes who borrows. And an “incentive effect”: it changes what borrowers do with the money (p. 393).
What they found
“those who are willing to pay high interest rates may, on average, be worse risks” Stiglitz & Weiss (1981), p. 393
The careful borrowers, with safe projects, drop out first as the rate rises. The ones still applying are more likely to be betting on a long shot. And borrowers facing a higher rate choose riskier projects to cover it. So the bank’s expected return rises with the rate for a while, then falls. The price stops doing its usual job:
“When the price (interest rate) affects the nature of the transaction, it may not also clear the market.” p. 393
The bank’s best move is to hold the rate where its return peaks and turn some applicants away, rather than raise rates or demand more collateral, which “could increase the riskiness of the bank’s loan portfolio” (p. 408).
“We have presented a model of credit rationing in which among observationally identical borrowers some receive loans and others do not.” p. 408
Stiglitz shared the 2001 Nobel prize in economics with Akerlof and Spence.
What it means
The terms of an offer are a filter. Change them and you change who shows up, not just how many. When that happens, the “right” price isn’t the one that brings in the most volume.
Where it shows up in a revenue team
- Loosening terms (lower minimums, faster approvals, less paperwork) clears more volume and changes who applies.
- An approval-rate target pushes underwriting to say yes more often, and the extra yeses come from the riskiest end of the pool.
- The customers happiest to pay up aren’t always the best ones. In lending, the borrowers keenest on expensive money can be the least likely to pay it back.
- Judge a change in terms by the book it produces, a year on, not by the applications it brings in this month.