NPR had a story this morning about the rise of loan sharking in Italy as a fallout from the credit crisis.  The question to ask is why is the credit crunch affecting banks but not loan sharks?  Credit is credit so why does the credit crisis make lending cheaper for loan sharks than for banks?  Put differently, if loan sharks have an advantage over banks why didn’t they have the same advantage before the crisis?

A simple story is based on a fundamental problem with the way credit markets operate.  The market for credit is like any other market with supply and demand and a price.  The price is the interest rate.  The problem with the credit market is that the price often cannot serve its usual market-clearing purpose.  When the supply of credit goes down, the interest rate should rise to clear the market.  Clearing the market means reducing demand to bring it back in line with the low supply.  The problem is that high interest rates reduce demand by disproportinately driving away borrowers who are good credit risks and leaving a pool of borrowers who are now more risky on average.  This makes lending even more costly, reducing supply, driving the price up again…

The effect is that there may be no way to clear the market by raising interest rates.  Instead credit must be rationed. This is part of the story of the credit crisis.  By itself it doesn’t explain the rise of loan sharks yet because loan sharks face the same problem.

One way to improve rationing is to increase collateral requirements. But borrowers who are already excessively leveraged (the other part of the credit crisis story) will not have additional collateral to compete for the rationed loans.  Here is where the loan shark comes in.  Loan sharks use a form of collateral that banks do not have access to:  kneecaps.  Highly leveraged borrowers who are rationed out of the credit market cannot post collateral to service their debt so they turn to loan sharks.