Question

You are a banker and are confronted with a pool of loan applicants, each of whom can be either low risk or high risk. There are 600 low-risk applicants and 400 highrisk applicants and each applicant is applying for a $100 loan. A low-risk borrower will invest the $100 loan in a project that will yield $150 with probability 0.8 and nothing with probability 0.2 one period hence. A high-risk borrower will invest the $100 loan in a project that will yield $155 with probability 0.7 and nothing with probability 0.3 one period hence. You know that 60% of the applicant pool is low risk and 40% is high risk, but you cannot tell whether a specific borrower is low risk or high risk. You are a monopolist banker and have $50,000 available to lend. Everybody is risk neutral. The current riskless rate is 8%. Each borrower must be allowed to retain a profit of at least $5 in the successful state in order to be induced to apply for a bank loan. You have just learned that 1,000 loan applications have been received after you announced a 45% loan interest rate. You can satisfy only 500. What should be your optimal (profit-maximizing) loan interest rate? Should it be 45% (at which you must ration half the loan applicants) or a higher interest rate at which there is no rationing?

Answer 1

You are a banker and are confronted with a pool of loan applicants, each of whom can be either low risk or high risk. There are 600 low-risk applicants and 400 highrisk applicants and each applicant is applying for a $100 loan.