Although I think the point of the Stiglitz model is to explain the movement and dynamics of interest rates and the effect of monetary policy, it offers some insights into how bank's behavior can deviate from the "normal way" banks behave.
"Equity markets are imperfect so that firms cannot fully divest themselves from the risks they face so they borrow. There is a probability that they may not be able to meet their debt obligation- that they may go bankrupt. Because the costs of bankruptcy are high, firms will act in a risk-averse manner. How risk adversely they behave depends on their net worth"
How does this fit into what was actually happening during and after the most recent financial crisis?
Investment bank's net worth was strong on the books, but they must have known that they were actually buying crap and selling crap since they bet against it. Perhaps the model shouldn't depend on "net worth" but perceived net worth, or the net worth of all other banks, or the net worth that everyone agrees upon. Sort of like Keynes' beauty contest.
The heart of the credit rationing model, in my view, is that banks will loan when it is profitable to loan. This makes some sense. Even at higher interest rates, banks may not make loans because their expected profit is not maximized because of adverse selection - the people most willing to pay a high interest rate are the ones most likely to default. However, juxtaposing this with the fact banks were pushing out subprime loans to anyone who could sign a paper doesn't agree with this type of risk argument. The difference was that there was "no skin in the game" for all parties. Originators, packagers, sellers, raters, and buyers (thought they were great investments).
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