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Credit, Loans and Financial Institutions

Financial institutions provide credit, funds and finance to non-financial institutions and households. The relationships between financial institutions and non-financial institutions may be viewed in terms of market relationships in a perfectly competitive market where there is trade under conditions of anonymity and tendency to uniformity of price. But, as Stiglitz and Greenwald (2003, p. 26) amongst others argue, interest rates cannot be parametric prices, the interest rate set varies with credit risk assessment rating of potential borrowers and amount to be borrowed, and the markets for capital, loans and credit cannot be treated like an auction market. The nature of the relationships between financial institutions and customers becomes highly relevant for the ways in which finance and credit are provided, on what terms and to whom, and the monitoring and other efforts of financial institutions to ensure the repayment of loans. It is then in the nature of credit that there will be what may be termed credit rating and pricing of credit which reflects assessment of likelihood of default (partial or total). Informational problems give rise to equity rationing as well as to credit rationing, and firms will be limited in their ability to raise equity capital. And it is often observed that a rather small proportion of new funds are raising through issue of new equity (Stiglitz and Greenwald, op. cit., p. 34), and indeed through share buy-backs and mergers the contribution of equity markets to additional funding can be negative.

The financial sector operates in the provision of funds to industry to favour some types of firms over others. It is a frequently expressed argument that there is, in some sense, a lack of funding for small and medium-sized enterprises. In a similar vein, research and development activities may not secure sufficient funding from external sources. A major and obvious difficulty here is the finding of the appropriate benchmark against which to judge whether there is the right level of funding for, say, small and medium-sized enterprises and at the ‘right price’. In a world of risk where the probability of default by a given category of borrowers is well established, it would be rather straightforward to assess whether banks were using the correct information, though asymmetric and moral hazard problems would blur the picture. In a world of fundamental uncertainty there is no firmly established benchmark of the likelihood of default by a borrower. The likelihood of default has to be assessed by the borrower without a clear benchmark of what that likelihood is.

The credit allocation processes depend on risk assessments which in an uncertain world can only be perceptions of frequency of default, etc., rather than based on well-established probability distributions. There have been many large literatures on how banks and other financial institutions approach lending to different social, ethnic groups and gender and in effect discriminate against some and practice financial exclusion. There are other literatures on lending to SMEs (small and medium-sized enterprises), lending for innovation, research etc., which have tended to express concerns over the lack of finance for those type of firms and activities.

The pervasiveness of credit rationing extends across all types of financial systems. Financial systems and subsystems will differ in how credit rationing is dealt with, how it impacts on who receives credit and at what price. Two broad comments may be made. The first is that financial systems develop what appear to be discriminatory practices through favouring some groups over others in their credit rating assessments. The discrimination can be along ethnic lines, gender, area of residence etc.

The second is that relational banking and similar arrangements develop to aid credit assessment and to ease monitoring issues. Causal observation suggests that the nature of the relationship, e.g. short-term vs. long-term, spot market vs. contractual, between banks and (potential) borrowers differ substantially between countries. The ways in which the monitoring and assessment issues are addressed clearly differ substantially between financial systems.

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