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Interest rate

Figure 2.1

Adverse selection example (a). At gross interest rats between k + A and y the bank earns a profit and both safe and risky types want to borrow. Safe types leave the market once interest rates rise above y, and the bank loses money. Once gross interest rates are pushed up to k/ p, the bank can again earn profits, while serving only risky borrowers. At gross interest rates above y/p even the risky borrowers leave the market.

Figure 2.1

Adverse selection example (a). At gross interest rats between k + A and y the bank earns a profit and both safe and risky types want to borrow. Safe types leave the market once interest rates rise above y, and the bank loses money. Once gross interest rates are pushed up to k/ p, the bank can again earn profits, while serving only risky borrowers. At gross interest rates above y/p even the risky borrowers leave the market.

Interest rate

Figure 2.2

Adverse selection example (b). Here, the "risky" types are riskier than in example (a) in figure 2.1. Now the "safe" types can never be served by a bank aiming to breeak even (since profits are negative even at interest rate y). The bank must raise gross rates to k/p to earn profits, at which price the bank will only attract risky borrowers. At gross interest rates above y/p, the risky borrowers leave the market.

Interest rate

Figure 2.2

Adverse selection example (b). Here, the "risky" types are riskier than in example (a) in figure 2.1. Now the "safe" types can never be served by a bank aiming to breeak even (since profits are negative even at interest rate y). The bank must raise gross rates to k/p to earn profits, at which price the bank will only attract risky borrowers. At gross interest rates above y/p, the risky borrowers leave the market.

Assuming that the bank's setup costs are covered, the market is efficient, with no credit rationing. While expected profits rise between Rb = k + A and y, the bank will set the gross interest rate at k + A since it is only trying to break even. Note that if the bank pushed interest rates above y, it would lose all of its safe clients and immediately lose money. In that case, the prudent bank would either reduce interest rates—or raise them. If the bank raised rates, it would have to increase rates all the way to k/p, in order to cover expected costs while serving only risky borrowers. Profits again rise as the interest rate is pushed above k/p, but the market collapses when rates rise above y/p. Above that rate, no one is willing to borrow. The example shows that raising interest rates does not necessarily increase profits in a linear way. As illustrated in figure 2.1, the peak at y may be higher than the peak at y/p, indicating that the greatest profits are earned at the lower interest rates.14

Figure 2.2 shows a situation in which the "risky" types are riskier than before. Now the "safe" types can never be induced to enter the market: even at interest rate y the bank fails to earn a profit. If the bank raises rates up to k/p, it can finally earn profits, but it will serve only risky borrowers. The bank's information problems preclude serving the safer individuals, and the outcome is both inefficient and inequitable.

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