Why Banks Say No Instead of Charging More

What they were looking at

They were looking at bank lending. A lender can screen applications, but it still can’t fully see how risky each borrower is. The textbook says that when there are more borrowers than money to lend, the price of money (the interest rate) goes up until the market clears.

Stiglitz and Weiss pointed out that raising the rate has two side effects. There’s an “adverse selection effect,” because it changes who borrows. And there’s an “incentive effect,” because 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

What happens as the rate goes up? The careful borrowers, with safe projects, drop out first. 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, and then it falls. At that point 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

So what’s the bank’s best move? 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 your offer work as a filter. When you change them, you change who shows up as well as how many. And once that’s true, the “right” price is no longer the one that brings in the most volume.

Where it shows up in a revenue team

• Raising the price on risk (a higher rate, a bigger fee, a reserve) changes who applies as much as who you approve. In the model, the safest borrowers are the first to walk away.
• An approval-rate target pushes underwriting to say yes more often. That isn’t in the paper, but the same logic says the extra yeses come from the end of the pool the screen was there to catch.
• The customers happiest to pay up aren’t always your best ones. In lending, the borrowers keenest on expensive money are the least likely to pay it back.
• Judge a change in terms by the book it produces a year later. The applications it brings in this month won’t tell you.