Contrary to what is consistently assumed in the literature, the return function cannot be humpshaped in the Stiglitz-Weiss (1981) model. This has important consequences for the possible occurrence of credit rationing and redlining. With a single class of borrowers, banks offer credit in two stages. Demand possibly exceeds supply in stage one, but not in stage two. With several observationally distinguishable borrower classes, the firms in a borrower class are redlined only under circumstances which imply that they would not get credit in a perfect capital market either.
JEL classification: D82, E51, G21Key words: credit rationing, redlining, asymmetric information.In one of the ground-breaking papers in financial economics, Joseph Stiglitz and Andrew Weiss (1981) analyze several models of "Credit Rationing in Markets with Imperfect Information". When Stiglitz was awarded the Nobel Prize in Economics in 2001, together with George Akerlof and Michael Spence, this article was mentioned implicitly in the press release and explicitly in the advanced information (see http://nobelprize.org/economics/laureates/2001/press.html). The most prominent of these models, used in many subsequent research papers and reproduced in many textbooks and survey articles, is the one with a continuum of borrower types endowed with projects with identical expected internal rates of return and with non-observable riskiness. In this paper, we re-examine this model. Stiglitz and Weiss (1981, pp. 394, 397) and the contributors to the strand of the literature originating from their seminal work derive several propositions using the assumption that the return function (i.e., the relation between the interest rate charged and the resulting expected rate of return on lending)is hump-shaped, with a unique interior maximum. Our point of departure is the observation that, actually, the return function cannot be hump-shaped. It is not necessarily monotonic, but it attains its global maximum at the maximum interest rate beyond which there is no demand for credit. In view of this, it is curious to see how the hump shape has been making its way into articles and textbooks ever since the publication of Stiglitz and Weiss (1981). Even so, this flaw would not be very remarkable if the hump shape assumption served expositional convenience only, while the substance of the analysis were unaffected. We proceed to show that this is not so. With a single class of borrowers, equilibrium credit rationing can occur with a hump-shaped return function. Taking into account the fact that the return function is not hump-shaped, banks offer credit in two stages. In equilibrium, there may be excess demand in stage one, but not in stage two. The question of whether credit rationing then prevails becomes a semantic issue. Moreover, having introduced observationally distinguishable classes of firms to their model, Stiglitz and Weiss (1981, pp. 406-407) emphasize the possible prevalence of "redlining" (i.e., entire classes of firms being excluded from the credit mar...
