Political Economy of Directed Credit

Imagine you are a bank manager and you have to decide to whom you will lend money. One prospect is an industrial company and the other is a farmer. As someone who wants the largest possible profits, you will look at each person’s credit worthiness and the interest rate and decide based primarily on these two factors. If the farmer is a riskier borrower but is willing to pay a high enough rate of interest to compensate for this risk, then you may very well decide to lend to the farmer. The same is true for the industrialist. In this stylised example, whoever values the loan more will receive it so the borrower is better off because he is willing to pay more later for money now, and the lender is better off because he is earning the highest possible profit. And the person who did not receive the loan is free to go to a competing banker and borrow money from there or to forgo the loan altogether. [Working Paper No. 0030]