Credit Rationing with a Moral Hazard Problem

Jeeman Jung

Assistant Professor of Economics, Sangmyung University, Seoul 110-743, Korea, Tel: +82-2-2287-5189, Fax: +82-2-396-5702 jmjung@pine.sangmyung.ac.kr

JEL Classification: G21, G32

Abstract

This paper examines an alternative model of credit rationing when moral hazard is present in the credit market. Two regimes are considered: one with a continuous trading assumption and the other with a restriction on trading. Continuous trading enables one to construct a riskless hedging portfolio and therefore leads to market failure. Under restrictions on trading, however, the entrepreneur of a firm does not undertake an extremely risky activity and the optimal strategy depends on the amount of debt: the larger the amount of debt, relative to the value of a firm's assets, the greater the entrepreneur's incentive to follow a risky strategy. In this situation, credit rationing is beneficial to lenders.

Keywords:

Moral hazard, Credit rationing, Continuous trading

Acknowledgments

I wish to acknowledge the financial support of the Sangmyung University.

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