Loan Rate Deregulation and Credit Market Signalling Equilibrium

In many developing nations, one of the regulations being phased out is the requirement that banks apply a common loan rate to all borrowers. Abolishing such a requirement allows banks to charge risk-adjusted loan rates based on borrowers' credit qualities. To better understand the economic consequences of loan rate deregulation, this paper analyzes its effects on aggregate credit supply and social welfare. We show that in the full information scenario when banks fully observe individual borrowers' credit qualities, both aggregate credit supply and social welfare increase with the deregulation. In the asymmetric information scenario when banks do not observe them, on the other hand, aggregate credit supply is likely to increase but the effect on social welfare is in general ambiguous. The reason why aggregate credit supply is likely to increase is because, in order to credibly signal their true credit qualities to banks, higher credit quality borrowers demand more than what they'd have demanded at the common loan rate. Due to this over-investment possibility, social welfare could decrease.