Government Lending as a Tool to Mitigate the Effect of Asymmetric Information

Abstract

This paper analyzes the effect of asymmetric information on investment efficiency and the ways in which government credit can mitigate the inefficiency caused by asymmetric information. The focus is on credit rationing. In the model, the project return and the project risk are assumed to be independent random variables. Under this assumption, asymmetric information produces two types of inefficiency: exclusion of good borrowers and inclusion of bad borrowers. Using a subsidy, the government can improve the composition of borrowers (average project return) in the sector where information is opaque (opaque sector) and increase the volume of loans in the opaque sector. The best way to improve investment efficiency is that the government sets the lending rate above the profit-maximizing level (lower lending rate adjusted for the default rate), bids up the funding rate to raise more loan funds, and makes up the difference between the high funding rate and the low adjusted lending rate with a subsidy. A subsidized loan guarantee covering a moderate portion of loan losses can produce similar outcomes. This result is a dramatic deviation from the conventional notion of a subsidized loan, which almost automatically means a lower lending rate.