Soft Collateral, Bank Lending, and the Optimal Credit Rating System

Abstract

We study the optimal credit rating system in a general equilibrium steady-state setting where borrowers can default strategically and future access to credit markets serves as "soft" collateral to enforce loan repayment. We start with simple schemes that set probabilities for exclusion after default and subsequent reinstatement of clean credit records. When there are sufficient funds, optimal credit stringency is as loose as possible subject to borrowers' incentive constraints. When there are insufficient funds, credit stringency is driven by the need to equilibrate non-excluded borrowers with available funds, and the stringency increases as the imbalance grows. We examine how population growth, mortality, and persistence affect our results. Finally, we compare the simple two-tier scheme with the three-tier scheme and characterize solutions to a general N-tier rating system. We show that a more graduated rating system is not necessarily a better one.

Keywords: Soft Collateral, Bank Lending, Credit Rating, Credit Registry

JEL Classification: D83, D86, G21, G24, G28