A situation where lenders become unwilling to advance additional funds (loans) to borrowers at the prevailing market interest rate (commercial loan rates). Therefore, the demand for commercial loans exceeds the supply of such loans at these market rates. The situation persists even at higher interest rates.  In other words, changes in the interest rate cannot be used to accommodate the excess demand for loans in the market. The lender’s supply function turns into perfectly price inelastic at certain point. This problem arises due to information and control limitations in financial markets (per se, an extreme case of the more general problem of capital market misallocation).

As a solution, a central bank reacts by limiting the maximum amount of loans and advances and, also in certain cases, setting a ceiling for specific categories of loans and advances. It determines a maximum limit for loans that a commercial bank can extend to a particular sector or at large.

Credit rationing restricts the flow of credit into undesirable sectors and redirects it into certain sectors where the central bank aims to accommodate. For example a central bank may react, in such an environment, by raising the maximum ceiling on agriculture sector to promote the flow of credit thereto, in order to stimulate this sector.