Credit Rationing with a Moral Hazard Problem

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.