A Business Encyclopedia

Credit Rationing

Definition: The Credit Rationing is a measure undertaken by the central bank to limit or deny the supply of credit based on the investor’s creditworthiness and an increased loan demand.

In other words, a situation where the central bank denies credit to the borrowers who want funds and are willing to pay a higher interest rate is called a credit rationing. This situation arises because of market imperfection or market failure as in spite of a demand for funds at a current rate the lender is not either willing to loan more funds or increase the interest rates.

Credit rationing is often applied in the situations where there is a shortage of institutional credit available for the business sector, the big and financially strong institutes try to capture a larger portion of the institutional credit. As a result of which, the priority sector often the weaker, but essential industries are deprived of necessary funds, mainly because the bank credit is given to the non-priority sectors. In order to control this situation, the central bank resorts to credit rationing measures. Typically, three measures are adopted:

  • Imposing an upper limit on the credit available to the big firms or industries.
  • Charging a higher and progressive interest rate on the loan amount after a certain limit.
  • Offering credit to the weaker sectors at lower internal rates.

All these measures are mainly undertaken with a view to making the credit available to the weaker industries. The credit rationing results not necessarily due to a credit shortage, but also due to asymmetric information.

The forms of credit rationing can be distinguished as; (i) rationing arising when the investor is not able to provide sufficient collateral, (ii) when specific group members, sharing the identifiable traits cannot obtain credit because of the supply of loanable funds, but can be obtained if the supply is increased. These group members will not get loans even if they pay a higher interest rate. This situation is called as Redlining, (iii)  Pure credit rationing is a situation where the group members with indistinguishable traits, some obtain credit while some do not and will not get it even if they pay a higher interest rate, (iv) Disequilibrium credit rationing is a feature of the market occurred due to some friction preventing the clearance of the credit.

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