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Credit markets help align the demand and supply for loanable funds. They help match borrowers and lenders with different risk preferences and time horizons. Demand for loanable funds mainly comes from household consumption choices, business investment decisions, and government borrowing. Supply of loanable funds mostly originates from household savings, company profits, and foreign investors.

Since individual creditors typically have limited ability to acquire and process information on candidate borrowers, they tend to be less willing to supply loanable funds or only for shorter periods and require stricter terms (greater risk premiums—higher fees, interest, collateral, etc.). Financial systems (banks, stock markets, and other lenders) have evolved to pool savings and collect information on borrowers to overcome these and other credit market imperfections.

One of the most widespread credit market imperfections is the problem of “asymmetric information.” Creditors and lenders face a challenge of evaluating borrowers, both before (ex-ante) funding a loan, and after (ex-post) the loan is issued. Borrowers can have hidden information about their risk of repaying a loan that is difficult for lenders to acquire. They might also be inclined to take bigger risks after being issued a loan, which may be hard for lenders to observe.

Hidden information by borrowers which materially impacts their ability to meet the terms of a loan can steer lenders to over-issue or underprice loans—i.e. the problem of “adverse selection.” Lenders also face the risk of over-issuing or underpricing loans to borrowers who engage in riskier behavior after the loan is issued—i.e. the problem of “moral hazard.”The challenge of “asymmetric information” (adverse selection and moral hazard) increases transaction costs. These include ex-ante costs of acquiring and processing information on the borrower and setting suitable terms for the loan, as well as ex-post costs to monitor the loan.

Banks (and similar institutions) have evolved to pool loanable funds from individual creditors who otherwise might be reluctant to lend money to individual households or businesses, or for activities they know little about. By collecting and combining loanable funds, banks enjoy economies of scale and scope that allow them to reduce transaction costs of acquiring and processing information on multiple borrowers, and to set better risk-adjusted lending terms. In supplying loanable funds to multiple diverse businesses and consumers, banks also spread risks that would otherwise face individual creditors (depositors).

Financial instruments that can be traded and used to manage risk—stocks, bonds, etc.—have been developed to help overcome credit market imperfections. These financial instruments combined with banks’ lending activities allow individual creditors to diversify risks across a variety of borrowers, reducing the impact of any individual default.

Overcoming credit market imperfections helps lower transaction costs and expand the demand and supply for loanable funds. This increases the quantity and quality of investments that can contribute to local and regional economic growth and development. Crediture’s advanced data analytic capabilities can benefit both lenders and borrowers in acquiring and processing information and monitoring loans to help overcome credit market imperfections.

Francois Melese, Ph.D.

Author Francois Melese, Ph.D.

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