Credit Rationing

Another result, as demonstrated by Stiglitz and Weiss (1981), is that information asymmetry can result in credit rationing in which some borrowers are arbitrarily denied loans. This occurs because a higher interest rate leads to even greater adverse selection: the borrowers with the riskiest investment projects will now be the likeliest to want to take out loans at the higher interest rate. If the lender cannot identify the borrowers with the riskier investment projects, he may want to cut down the number of loans he makes, which causes the supply of loans to decrease rather than increase with the higher interest rate.Thus, even if there is an excess demand for loans, a higher interest rate will not equilibrate the market because additional increases in the interest rate will only decrease the supply of loans and worsen the excess demand for loans even further. Indeed, as Mankiw (1986) has demonstrated, a small rise in the riskless interest rate can lead to a very large decrease in lending and possibly even a collapse in the market. when many investor withdraw lot of funds and banks cant give back enough money to lender or saver and forcing banks either to sell other investments to make up for the collapse.

It is a situation when the value of financial institution drops rapidly. Many financial crisis are associated with bank panic.

Causes and consequences of financial crisis are

Leverage