Financial markets in developing countries (rough notes, use only as guidance; more details provided in lecture) The role of the financial system

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1 Financial markets in developing countries (rough notes, use only as guidance; more details provided in lecture) The role of the financial system matching savers and investors (otherwise each person needs to save up by themselves) providing payment services (instead of carrying cash) generating and distributing information reflected in stock, bond prices, etc. 1

2 allocation of credit/capital in the economy (to the uses that yield greatest returns) pricing, pooling and trading risk (through the insurance market, part of the financial system) providing asset liquidity (some investments are long-lived; but can be made liquid through the stock market, etc.) 2

3 Credit markets matching skills with resources if financial markets are efficient (perfect information, perfect enforcement) then resources flow to highest returns (highest skills) otherwise, economic outcomes depend on how much wealth people start with, not their talents thus, financial markets are important for efficiency, for the economy to reach its potential 3

4 Why are financial markets particularly likely to be imperfect in developing countries? Buying something vs. paying are often separated over time Presence of transaction costs when the time to pay comes people can be: unable to repay (information needed in advance to prevent this; this is costly) unwilling to repay (enforcement needed ex-post to prevent this; this is costly) evidence from India: in 1997, 3.2 outstanding debt cases; 40% for more than 8 years also, limited liability in today s world there are legal limits on punishment for reneging on contracts (not true in the past or in black markets) 4

5 Lenders anticipate these issues, so they: screen borrowers (if asymmetric information problem in borrower s riskiness/type) monitor borrowers (if asymmetric info in borrower s effort if cannot observe it) threaten to cut off from future loans (to help with enforcement problems) require collateral (to help with enforcement problems) 5

6 FACTS high interest rates in LDCs (Banerjee, 2004) 52% in rural areas in India; 28-62% in urban; in the US 6-14% cannot be explained by default alone (explains at most 23% of the interest rate level) cannot be explained by monopoly power alone why kill the demand so much? also, public banks and competition from informal sector present presence of large informal sector, including moneylenders (provides 20-30% of all loans) personalized interest rates (co-existence of various rates, e.g. 12% vs. 60% without arbitrage) loan amount often restricted by borrower s wealth/assets no more loans possible, no matter what the interest rate credit rationing 6

7 some people not given a loan of any amount and at any offered interest rate (not consistent with standard supply and demand theory under perfect markets) 7

8 Evidence for transaction costs: the case of Debt Recovery Tribunals in India (Visaria, 2007) sped up resolution of civil cases about unpaid loans; reduced loan delinquency by 6-11 percentage points interest rates fell by 1-2 percentage points Cross-country evidence (Djankov et al. 2006) study 129 countries over 25 years finds that lenders legal rights (ability to enforce repayment; sell the collateral) is positively correlated with the private debt to GDP ratio 8

9 Financial development and growth (Rajan and Zingales, 1998) across countries the size of domestic credit market positively correlated with GDP per capita however, causality can run the other way around richer countries may have larger market for credit or, both can be caused by third factors (institutions, good government policies) however, they also find a strong positive evidence on financial development on growth of industries that are more credit-dependent. King and Levine (1993) find positive correlation between higher initial levels of financial development and subsequent growth (controlling for many country and policy characteristics) 9

10 THEORY Three major problems causing financial market imperfections 1. Limited enforcement borrowers can default even if able to pay 2. Moral hazard unobserved effort by borrowers affect the probability of successful investment, hence repayment 3. Adverse selection unobserved characteristics by borrowers (e.g., riskiness) affect probability of repayment the reason for the market imperfections/failure is either contract enforcement problem (1.) or asymmetric information between lenders and borrowers (2. and 3.) 10

11 Limited Enforcement Example suppose the borrower can choose not to repay since probability of getting caught (loan enforced) is π<1 limited enforcement penalty if default and caught is F ; interest rate r, e.g. 20% (i.e. for $1 borrowed must return $(1 + r), e.g. $1.20) investment of I needed to set up production; borrower has initial wealth A<I borrower borrows I A output is q (if investment made) the borrower will not default if: q (1 + r)(i A) >q πf (1) 11

12 the above inequality says that the income if not default (left hand side) should be larger than the expected income if default (escape with the money) the right hand side from (1), we obtain that default will not happen as long as: A>I πf 1+r (2) thus, only people with high enough wealth will be lent to (the lender will not lend to someone they know will default; think of F as jail time, etc. not something that the lender gets). note how the limited enforcement problem creates credit rationing and inefficiency! some poor people will not obtain loans, even if their business projects are profitable (say q>(1 + r)i) 12

13 the minimum wealth necessary to borrow depends on πf the highr the fine or the probability of repayment the more people will be able to borrow. On the other hand, the higher I (i.e., the loan required) or the interest rate, the higher the wealth threshold. Note if the right hand side in (2) is negative then any person can borrow. refusing future loans or interlinking can alleviate the above problems 13

14 Moral Hazard Example suppose output from a business can be either high (success), y H =2or low (failure), y L =0 the probability of success is a function of borrower s effort, e; assume for simplicity prob(y H )=e and prob(y L )=1 e. putting effort is costly, cost 1 2 e2 investment I =1required to run business; opportunity cost of funds, ρ assume y H > (1 + r)i i.e. the investment is worth doing (2 > 1+r) Case I: self-financed entrepreneur max e e(2) ρ(1) 1 2 e2 14

15 takethederivativeandsettozerotofind the optimal effort level: e =2 15

16 Case II: borrowing when effort is observable (no incentive/moral hazard problems) the efficient effort level e will be achieved if it is possible to monitor effort. assume the lender is only paid in case of success (the borrower has nothing otherwise) The lender s expected profit is:π L = ei(1 + r) ρi = e(1 + r) ρ the borrower s expected profit is Π B = e(y H (1 + r)i) 1 2 e2 = e(1 r) 1 2 e2 if effort is monitorable, the two parties will choose e in the the optimal way to maximize joint profits: Π = Π L + Π B =2e ρ 1 2 e2 which is exactly the same expression as that of the self-financed entrepreneur. the same, first-best effort level, e is obtained as a result. 16

17 Case III: moral hazard due to unobservable effort suppose now the lender cannot observe the effort the borrower puts in the borrower knows that when output is low he will pay nothing, while when output is high he must pay the interest; it s as if the borrower s success is taxed reduces his incentive to put in effort (a moral hazard problem occurs) The borrower chooses effort alone (to maximize his own income): max e e(y H ) e(1 + r)i (1 e)(0) 1 2 e2 =2e e(1 + r) 1 2 e2 take the derivative and set to zero: 2 (1 + r) e =0 17

18 or, e MH =1+r whichislessthane (see above) the moral hazard problem leads to lower effort, and inefficiency (higher default rates than in the first best; lower expected output). possible role for collateral: a collateral requirement (making the borrower lose something in the low output case) will alleviate the moral hazard problem by increasing incentives to work hard 18

19 Adverse Selection Example supposetherearetwotypesofborrowersinthepopulationwithdifferent probability of success of their business projects projects either succeed (positive output) or fail (zero output) risky borrowers have prob. of success 1/2 in which case they get return of 4 safe borrowers have prob. of success 1 in which case they get return of 2 note, the expected return is the same (2) in both cases but the risky types have uncertain (variable return, 4 or 0) vs. the sure return from thesafetypes. both types need a loan of size L =1to start up their investment project risky borrowers default (can t pay anything) if their project fails 19

20 suppose the lender does not know the borrower s type ( asymmetric information, since borrowers know their type) If they knew easy what to do just charge different interest rates to both types (higher for the risky ones) However, with unobserved type this is impossible the same interest must be charged since unable to tell who is who a given loan interest rate may attract very different pools of borrowers depending how high it is if the interest rate set by the lender is low, both types will apply for a loan however, setting a high interest rate will only attract the risky types (since they only pay back when their project succeeds) note, the risky type expected income is (1/2)(4)+(1/2)(0) (1/2)(1+ r)l =2 (1/2)(1 + r) so they will borrow up to an interest rate of 20

21 r =3(thisisthemaximumr at which they get at least zero expected income) for safe types, their expected income is 2 (1 + r)l =1 r so they ll only borrow if r 1. This is called adverse selection problem the level of the interest rate set determines the pool of borrowers a lender faces setting higher price (interest rate) instead of yielding higher profits (like in a conventional market) may result in facing increasingly more risky borrowers and actually decrease profits. Thus, an (inefficient) equilibrium may result in there is excess demand for loans (credit rationing again) but lenders don t raise the price (the interest rate) as this may reduce their profits due to the adverse selection effect. other examples of adverse selection in insurance markets plans with very small deductibles likely to attract very risky clients 21

22 role for collateral again: if the lender offers two contracts: one with low r but high collateral and one with high r but low collateral borrowers will self-select into them (safe will pick low r, risky will pick high r) can show this can restore efficiency (obtained in the benchmark with no asymmetric information) 22

23 APPLICATIONS/POLICY the above theoretical considerations explain the relative success of certain innovative credit mechanisms in developing countries such as microcredit ROSCAs (rotating credit and savings associations) in the presence of credit market impeftections (credit rationing) often formed in LDCs to facilitate buying expensive households asset (e.g. TV, washer) or business assets (e.g. motorbike) group of people make monthly contributions and one (often randomly) chosen to take the pot each month on average, everyone but the last person to win the pot buys the asset sooner efficiency improvement issues: enforcement, how to ensure people keep contributing after winning; group size/composition matters 23

24 Microfinance institutions (MFI) microfinance: supply of credit, saving vehicles and insurance to poor people who are otherwise outside the formal financial sector (rationed out) original idea (Mohammad Yunus Grameen Bank in Bangladesh) group lending a group of borrowers responsible for a loan to one of its members meaning that if a group member does not pay all others are responsible for their loan; can be cut off from future credit typically, no collateral required very high repayment rates reported Why does it work? above. several reasons, related to the theory discussion 24

25 Moral hazard reduced since the group members can monitor each other (the bank effectively delegates these costs to the borrowers) Adverse selection reduced since the group members know each other and would form groups with people like them Enforcement problems reduced since group members can exercise peer pressure to ensure repayment Basically, instead of physical asset collateral, the group s superior information, monitoring and enforcement serves as social collateral that the lender can exploit to provide credit to poor people who would otherwise be rationed out by traditional, individual liability lenders such as commercial banks Other innovations used by MFI dynamic incentives at first small loans are given and new, larger 25

26 loans provided only if previous loans are paid (same as what credit card companies here do) flexible collateral accept items that are valuable to the borrower (e.g. wedding ring; working animals) even if not so valuable to the lender targeting women borrowers higher repayment rates achieved. Why? possible explanations are that women are more risk-averse (psychology) and that they have fewer outside options (lower incentives to default, nowhere to go ) 26

27 MFI and subsidies historically MFI have been subsidized by NGOs or governments should we keep subsidizing or require that MFIs start breaking even? are MFI a tool for re-distribution (to target the poorest potential microentrepreneurs) or filling in a profitable niche in the financial market? possible idea: tie microcredit to social services that are demanded only by the poor and are costly to participate in (act as screening mechanism to find out who really needs the money for more discusison see the case studies after ch. 5 and ch. 11 in the book 27