Problems in Rural Credit Markets
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1 Problems in Rural Credit Markets Econ 435/835 Fall 2012 Econ 435/835 () Credit Problems Fall / 22
2 Basic Problems Low quantity of domestic savings major constraint on investment, especially in manufacturing Dualistic credit market,! formal sector commercial and government run banks serving urban sector and large landowners,! informal sector small scale lenders and agricultural cooperatives serving small scale rural borrowers and the informal urban sector Skewed distribution of credit access a source of persistent and widening wealth disparity. Econ 435/835 () Credit Problems Fall / 22
3 Traditional "Development Planning" View Dominant paradigm (1960s / 70s) Monopolistic moneylenders, especially in rural areas Lack of nancial depth,! low savings due to uncertainty regarding potential bank failure and ine ective legal systems,! lack of alternative nancial assets catering to varying needs of potential savers/lenders. Econ 435/835 () Credit Problems Fall / 22
4 Policy Strategy put the moneylender in his place All India Rural Credit Survey (1950),! development banks introduced to lend at low rates to rural borrowers initially ll savings gap with tax revenue and foreign loans/aid Eventually development banks would become self nancing BUT,! failed to drive out informal moneylenders,! development banks did not become nancially viable,! access to formal credit has remained skewed towards wealthy Econ 435/835 () Credit Problems Fall / 22
5 The Chicago School View Dominant paradigm (1980s/90s) Informal sector is competitive, but risky and costly due to,! seasonal activity,! geographically dispersed, small-scale customers,! absence of collateral land is often untitled,! di culty of enforcing repayment ) high interest rates re ect risk and lending costs, not monopoly power Diminishing returns ) capital should naturally ow to poor,! borrowers could pay enough to compensate for risk, but usury laws prevent banks from charging high rates Econ 435/835 () Credit Problems Fall / 22
6 Policy Implication Government intervention is the problem,! removal of interest rate ceilings,! credit market liberalization pushed by external lenders BUT,! localized information limits competition,! interest rates often negatively related to risk,! information is a public good social bene ts exceed private bene ts,! no explanation for other institutional characteristics Econ 435/835 () Credit Problems Fall / 22
7 New Institutional View Credit market transactions typically involve asymmetric information Nature of credit market institutions re ects private sector response to this market failure,! formal sector vs. informal sector responses di er Signi cant entry of lenders in informal sector, BUT,! informational constraints,! market segmentation,! local market power Role for government, but must recognize informational disadvantages,! need institutional innovation ) micro nance Econ 435/835 () Credit Problems Fall / 22
8 Should Governments Intervene in Credit Markets? Two main rationales for intervention,! E ciency: are productive investments not being undertaken?,! Distribution: is access to credit equitable?,! there need not be a trade-o Agency Problems,! reasons for absence of formal institutions in village economies,! result of limited liability (lack of collateral) and asymmetric information,! even if land is titled, formal banks may not accept it as collateral Econ 435/835 () Credit Problems Fall / 22
9 Adverse Selection Example Investment requires $1, but borrowers have no wealth A fraction q of borrowers are safe : earn certain output y A fraction 1 q of borrowers are risky : ȳ with probability p Output = 0 with probability 1 p Bank cannot distinguish borrower types Equal expected return: pȳ =y. Gross cost to bank per $1 lent = k, where y > k Bank charges gross (interest plus principle) lending rate = R Econ 435/835 () Credit Problems Fall / 22
10 How does the bank s expected pro t vary with R? Given R, the bank s expected return per dollar lent is [q + (1 q)p] R De ne the break-even value of R as R b [q + (1 q)p] R b = k R b = k q + (1 q)p (1 q)(1 p)k R b = k + q + (1 q)p R b = k + A Bank s expected pro t: [q + (1 q)p] R k if R < y π = pr k if R > y Econ 435/835 () Credit Problems Fall / 22
11 π 0 k k+a y k/p y/p R Econ 435/835 () Credit Problems Fall / 22
12 π 0 k y k+a k/p y/p R Econ 435/835 () Credit Problems Fall / 22
13 Implications Raising interest rates need not increase pro ts linearly If p falls, the bank may not be able to break even at a rate low enough for safe borrowers ) Banks will only serve risky borrowers,! this is ine cient (since y > k) and inequitable,! credit rationing Econ 435/835 () Credit Problems Fall / 22
14 Moral Hazard Example (Ghosh, Mookherjee and Ray 2000) Indivisible project requires funds L All agents risk neutral Likelihood of high output depend on non-contractible e ort e : Q if good harvest with prob. p(e) Output = 0 if crop failure with prob. 1 p(e) where p 0 (e) > 0, p 00 (e) < 0 Econ 435/835 () Credit Problems Fall / 22
15 Case 1: Self nanced farmer (benchmark) Farmer chooses e to solve max e p(e).q e L,! FOC p 0 (e ) = 1 Q where e = rst best (e cient) e ort level Econ 435/835 () Credit Problems Fall / 22
16 Case 2: Debt nanced farmer Total debt: R = (1 + i)l Limited Liability: In case of default can only lose collateral, w < L Farmer chooses e to solve max p(e).(q R) + (1 p(e)).( w) e e,! FOC yields the incentive curve: p 0 1 (ê) = Q + w R,! ê(w, R) is decreasing in R and increasing in w,! if R > L > w, it follows that ê < e (IC) Econ 435/835 () Credit Problems Fall / 22
17 Lender s pro t: π = p(e)r + [1 p(e)] w L Competitive lending (Figure 1) ) π = 0 : R = L w p(e) + w = L (1 p(e))w p(e) (ZP),! equilibrium: determined by intersection of (IC) and (ZP) Monopoly lending ) maximize pro ts subject to IC (Figure 2),! if max pro t is π M then isopro t line is R = L πm (1 p(e))w p(e) (MP) Econ 435/835 () Credit Problems Fall / 22
18 R Isoprofit Curve Incentive Curve R^ E e^ e* e Figure 1: Equilibrium Debt and Effort in the Credit Market.
19 R Isoprofit Curve Incentive Curve E' R^ E e^ e* e Figure 2: Effect of an Increase in the Lender s Profit.
20 An increase in collateral, w (Figure 3),! fall in the equilibrium interest rate and debt, and an increase in the e ort level.,! for a xed π, the borrower s income increases ) interest rate dispersion, even in competitive credit markets ) exaccerbates pre-existing inequality Econ 435/835 () Credit Problems Fall / 22
21 R R ~ Borrower's indifference curve B Incentive constraint Isoprofit line A ~ L L * L Figure 4: Optimal Solution to the Enforcement Problem.
22 Enforcement Problems (Ex Post Moral Hazard) Example (Ghosh, Mookherjee and Ray 2000) In nite horizon lending borrowing game with no saving and discount factor δ Borrower s production technology is F (L) where F 0 (L) > 0 and F 00 (L) < 0 r = bank rate of interest (opportunity cost of funds) Self nanced farmer (benchmark): max L F (L) (1 + r)l,! FOC: F 0 (L ) = 1 + r Econ 435/835 () Credit Problems Fall / 22
23 Partial Equilibrium: Single Lender Assume that a defaulting borrower goes into autarky and receives v (exogenous for now) Borrower s incentive constraint: F (L) + Optimal contract solves δ 1 δ v 1 [F (L) R] (IC) 1 δ max L,R F (L) R subject to R δ [F (L) v] (IC) z = R (1 + r)l (PC) where z is lender s minimum pro t Econ 435/835 () Credit Problems Fall / 22
24 Two types of solution: (1) if indi erence curves are tangent to isopro t curve between A and B at L, this is the solution and IC is not binding (2) if not, both constraints are binding and solution ˆL(v, z) is at corner B,! in general, the constrained optimal level of lending is L(v, z) = min L, ˆL(v, z) Econ 435/835 () Credit Problems Fall / 22
25 Some Implications Increase in lender s pro t z! PC shifts up (Figure 5),! reduced lending, L,! increase in interest rate, R/L Increase in value of outside option, v! IC shifts down (Figure 6),! reduced lending, L,! increase in interest rate, R/L Can credit rationing arise in equilibrium?,! yes: if z or v become high enough there is no combination of L and R that satis es both (IC) and (PC) Econ 435/835 () Credit Problems Fall / 22
26 R Incentive constraint Isoprofit line L Figure 5: Effect of an Increase in Lender s Profit.
27 R Isoprofit Line B Incentive Constraint B' L Figure 6: Effect of an Increase in Borrower s Outside Option.
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