A Unifying Theory of Credit and Equity Rationing in Markets with Adverse Selection

In their 1981 model, Stiglitz and Weiss demonstrated that there may be credit rationing in markets with adverse selection. Work by Cho and DeMeza and Webb has subsequently shown that rationing would disappear in the 1981 model if entrepreneurs seek funds on an equity market, rather than on a credit market. Using a different set of assumptions, Myers and Majluf and Greenwald, Stiglitz and Weiss show that equity markets may also feature rationing. A question that remains is whether the models of credit and equity rationing can be made compatible. The analysis of DeMeza and Webb suggests that this is not possible in models with one- dimensional asymmetric information. In this paper we consider a model with two-dimensional asymmetric information: entrepreneurs know more about both the expected returns and the risk of their projects. We examine how entrepreneurs self-select between the credit and equity market, and ask whether in equilibrium there can be rationing in one or both of these markets. Our main result is that credit and equity rationing are not only compatible, but in fact that competition between the credit and equity market may give rise to adverse selection that generates these rationing equilibria. This paper represents the views of the authors and does not necessarily represent that of any organization with which they are or have been affiliated