Credit Market Problems in Developing Countriesqed.econ.queensu.ca/pub/faculty/lloyd-ellis/econ835/...Irfan Aleem (1990) Informal sector = 75% of rural lending Mean Interest Rates:

Credit Market Problems in Developing Countries

November 2007

() Credit Market Problems November 2007 1 / 25

Basic Problems (circa 1950):

Low quantity of domestic savings � major constraint on investment,especially in manufacturing

Dualistic credit market

,! formal sector � commercial and government run banks servingurban sector and large landowners

,! informal sector � small scale lenders and agricultural cooperativesserving small scale rural borrowers and the informal urban sector

Skewed distribution of credit access � a source of persistent andwidening wealth disparity.


The Development Planning ApproachDominant paradigm (1960s / 70s)

Monopolistic moneylenders, esp. in rural areas

Lack of ��nancial depth�

,! low savings due to uncertainty regarding potential bank failure andine¤ective legal systems

,! lack of alternatives �nancial assets catering to varying needs ofpotential savers/lenders.


Policy Strategy:

�put the moneylender in his place�

,! development banks to lend at low rates to rural borrowers

initially �ll savings gap with tax revenue and foreign loans/aid

Eventually banks would become self��nancing

BUT

,! failed to drive out informal moneylenders

,! development banks did not become �nancially viable

,! access to formal credit remained skewed towards large landowners


The Chicago School Approach

Informal sector is competitive, but risky and costly due to

,! seasonal activity

,! systemic risk

,! geographically dispersed customers

,! absence of collateral � land is often untitled

,! di¢ culty of enforcing repayment

) lack of information re�ects acquisition costs

) high interest rates re�ect risk not monopoly power


Lender�s risk hypothesis:

Pro�t per $ loaned = p(1+ r)� (1+ i)

where

r = lending rate

i = marginal cost of funds

p = probability of repayment

,! Competition ) zero economic pro�ts

,! risk�adjusted interest rate

r =1+ ip

� 1


S(r)

I(r)r

InterestRate

rd

S(r)

r *

I* S(rd)Savings,Investment

Figure: Implications of Interest Rate Ceiling


Policy implication: government intervention is bound to fail

,! removal of interest rate ceilings

BUT

,! information is a public good � social bene�ts exceed privatebene�ts

,! localized information limits competition

,! interest rates often negatively related to risk

,! no explanation for other institutional characteristics


Example: Credit Markets in Chambar, PakistanIrfan Aleem (1990)

Informal sector = 75% of rural lending

Mean Interest Rates: Formal = 12%, Informal = 79%

High degree of duality

Non�specialization by lenders

Interlinking of loan and commodity contracts

Informal sector: no collateral, but low default rates

Formal sector: collateral but high default rates.


New Institutional View

Credit market transactions are typically incomplete

institutions: private�sector response to market failure

signi�cant entry, BUT

,! informational constraints

,! market segmentation

,! �local�market power

) monopolistic competition

role for government, but must recognize informational disadvantages


Agency Problems

Reasons for absence of formal credit in village economies

A result of limited liability (lack of collateral) and asymmetricinformationEven when titled land is available, formal banks may not accept it ascollateral

Two main rationales for intervention

,! E¢ ciency: are productive investments not being undertaken?

,! Distribution: is access to credit equitable?

,! need not be a trade-o¤


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�:

Output =�y with probability p0 with probability 1� p

Bank cannot distinguish borrower types

Equal expected return: py =y .

Gross cost to bank per $1 lent = k, where

y > k

Bank charges gross (interest plus principle) lending rate = R


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 Rb

[q + (1� q)p]Rb = k

Rb =k

q + (1� q)p

Rb = k +(1� q)(1� p)kq + (1� q)p

Rb = k + A

Bank�s expected pro�t:

π =

�[q + (1� q)p]R � k if R < y

pR � k if R > y


0

π

Rk k+A y k/p y/p


0

π

Rk k+Ay k/p y/p


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 lowenough for safe borrowers

) Banks will only serve risky borrowers

,! this is ine¢ cient (since y > k) and inequitable

,! credit rationing


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 :

Output =�Q if good harvest with prob. p(e)0 if crop failure with prob. 1� p(e)

where p0(e) > 0 , p00(e) < 0


Case 1: Self��nanced farmer (benchmark)

Farmer chooses e to solve

maxe

p(e).Q � e � L

,! FOCp0(e�) =

1Q

where e� = �rst�best (e¢ cient) e¤ort level


Case 2: Debt��nanced farmerTotal debt:

R = (1+ i)L

Limited Liability: In case of default can only lose collateral, w < L

Farmer chooses e to solve

maxe

p(e).(Q � R) + (1� p(e)).(�w)� e

,! FOC yields the incentive curve:

p0(e) =1

Q + w � R (IC)

,! e(w ,R) is decreasing in R and increasing in w

,! if R > L > w , it follows that

e < e�


Lender�s pro�t:

π = p(e)R + [1� p(e)]w � L

Competitive lending (Figure 1) ) π = 0 :

R =L� wp(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 πM then isopro�t line is

R =L� πM � (1� p(e))w

p(e)(MP)


Isoprofit Curve

Incentive Curve

R

R

ee*e

E

Figure 1: Equilibrium Debt and Effort in the Credit Market.

by the lender’s market power (although that certainly exacerbates the problem), butthe agency problem itself, and the distortion in incentives created by limited liability.While the borrower shares in capital gains, he bears no part of the capital losses(beyond the collateral posted). Working with other people’s money is not the same asworking with one’s own.

The other extreme case is that of monopoly. In this case, the value of π is maximizedfrom among all feasible and incentive compatible alternatives. In other words, themonopolistic lender will choose the point on the incentive curve that attains the highestisoprofit curve. The condition is the standard one of tangency between the two curves.This provides a ceiling on the interest rate, or debt level (R), and the lender will notfind it profitable to raise it above this level. In more competitive conditions, this ceilingwill still apply. If, in a competitive credit market, there is excess demand for funds atR, the interest rate will not rise to clear the market. We have an exact counterpartof Stiglitz-Weiss type of rationing (rationing of borrowers, or macro-rationing in ourterminology) in the presence of moral hazard rather than adverse selection.10

10Stiglitz and Weiss (1981) discuss how their story can be recast as a moral hazard problem. How-ever, the incentive problem suggested there is somewhat different. With limited liability, borrowerswill prefer a mean preserving increase in spread in the distribution of returns. They will tend to pass

8

Isoprofit Curve

Incentive Curve

R

R

ee*e

E

E'

Figure 2: Effect of an Increase in the Lender’s Profit.

The observation that borrower-friendly equilibria are more efficient has broad im-plications for social policy. Any change which reduces interest rates, or improves thebargaining power of the borrower will enhance effort and productivity. The latterinvolves institutional changes, such as a reallocation of property rights over relevantproductive assets from lenders to borrowers, or an improvement in the latter’s outsideoptions (an issue elaborated in the Mookherjee [13] reading). Note, however, that suchpolicy interventions cannot result in improvements in Pareto efficiency — since equi-librium contracts are by definition constrained Pareto-efficient — but result in higherlevels of social surplus. In other words, they must make some agents in the economyworse off. Despite the fact that the gainers (borrowers) could potentially compensatethe losers, such compensations cannot actually be paid, owing to the wealth constraintsof the borrowers. Accordingly such policies will tend to be resisted by the losers, andmay not actually be adopted.

up projects with secure returns, and will instead select projects with high possible returns but alsohigh risk. An increase in the interest rate will reinforce this tendency.

9

An increase in collateral, w (Figure 3)

,! fall in the equilibrium interest rate and debt, and an increase in thee¤ort level.

,! for a �xed π, the borrower�s income increases

) interest rate dispersion, even in competitive credit markets

) exaccerbates pre-existing inequality


R

e

E'

E

Isoprofit Curve

Incentive Curve

Figure 3: Effect of Higher Borrower Wealth (Collateral).

These results illustrate how interest rate dispersion might arise, even in competitivecredit markets. In the presence of default risk and moral hazard, the interest rate willbe closely tied to borrower characteristics such as wealth or ability to post collateral.Wealthier borrowers pose less risk for two reasons: these loans have better guarantees incase of default, plus lower default risk arising from better incentives. Hence, wealthierborrowers have access to cheaper credit. Arbitrage opportunities are illusory—theisoprofit line restricts lenders to the same profit level for different types of borrowers.The second point of interest is that the functioning of the credit market may exacerbatealready existing inequalities. Those with lower wealth are doubly cursed: they not onlyface lower consumption potential from asset liquidation, but also lower income earningpotential, owing to costlier (or restricted) access to credit. The reason is that the poorcannot credibly commit to refrain from morally hazardous behavior as effectively as therich. This process of magnification of past inequalities through the operation of specificmarkets has been identified in different contexts by Dasgupta and Ray (Reading [9])and Galor and Zeira (Reading [4]), among others.

Long-term exclusive relationships and social networks can be useful in mitigatingthese inefficiencies to some extent. When the lender and borrower enter a long-livedrelationship, it expands the opportunity for the lender to relax limits on the borrower’s

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Enforcement Problems (Ex Post Moral Hazard)

Example (Ghosh, Mookherjee and Ray 2000)

In�nite horizon lending�borrowing game with no saving and discountfactor δ

Borrower�s production technology is F (L) where F 0(L) > 0 andF 00(L) < 0

r = bank rate of interest (opportunity cost of funds)

Self��nanced farmer (benchmark):

maxL

F (L)� (1+ r)L

,! FOC:F 0(L�) = 1+ r


Partial Equilibrium: Single Lender

Assume that a defaulting borrower goes into �autarky�and receives v(exogenous for now)

Borrower�s incentive constraint:

F (L) +δ

1� δv � 1

1� δ[F (L)� R ] (IC)

Optimal contract solves

maxL,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


Two types of solution:

(1) if indi¤erence curves are tangent to isopro�t curve between A and Bat L�, this is the solution and IC is not binding

(2) if not, both constraints are binding and solution L(v , z) is at corner B

,! in general, the constrained optimal level of lending is

L(v , z) = min�L�, L(v , z)


R

L

R~

L~

L*

Borrower's indifference curve

Incentive constraint

Isoprofit line

A

B

Figure 4: Optimal Solution to the Enforcement Problem.

subject to the constraints

R ≤ δ[F (L) − v] (10)

z = R − (1 + r)L (11)

(10) is simply the incentive constraint in (8), after rearrangement. The nature ofthe solution is illustrated in Figure 4. The boundary of the incentive constraint is thepositively sloped, concave curve with slope δF

′(L), while the lender’s profit constraint(11) is represented by a straight line with slope 1 + r. The points of intersection Aand B are where both constraints bind. Clearly, the line segment AB represents thefeasible set. The borrower’s indifference curves are rising, concave curves with slopeF

′(L), lower indifference curves representing higher payoff. If these indifference curvesattain tangency at some point on AB, it is the solution to the problem, and has theproperty: L = L∗, and R = (1+ r)L∗ + z. If not, the solution must be at the corner B.Let L(v, z) be the value of L at B, and let L(v, z) denote the solution to the problemabove (the corresponding value of R is given from (11)). The preceding discussion

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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 Rthat satis�es both (IC) and (PC)


R

L

Incentive constraint

Isoprofit line

Figure 5: Effect of an Increase in Lender’s Profit.

leads to the conclusion:L(v, z) = min{L∗, L(v, z)} (12)

If the second argument applies above (i.e, the solution is at the corner B), creditrationing will arise. We will show in a moment that this is possible. However, we firstanalyze the effect of a parametric shift in z (lender’s equilibrium profit) or v (optionvalue of default). If z increases (Figure 5), the iso-profit line shifts up and the pointB moves to the left, i.e, L(z, v) is decreasing in z. If this is indeed the solution, thenthe equilibrium volume of credit is reduced and rationing becomes more acute. If thesolution is interior (L∗) to begin with, a small increase in z will raise the interest rate,but will leave the loan size unaffected. Notice that the interest rate rises in the firstcase too, as indicated by the fact that the ray connecting point B to the origin becomessteeper.

Figure 6 illustrates the effect of increasing the borrower’s outside option v. Thecurve representing the boundary of the incentive constraint undergoes a parallel down-ward shift, moving the corner point B to the left. The effect on loan sizes and interestrates is nearly similar to the case of increasing z. If L = L∗ to begin with, nothingchanges (since v affects only the incentive constraint, which is not binding). If L = L,on the other hand, increasing v has the implication that the equilibrium loan size falls

15

R

L

Incentive Constraint

Isoprofit Line

B

B'

Figure 6: Effect of an Increase in Borrower’s Outside Option.

and the interest rate rises.Can credit rationing arise in equilibrium? To see that the answer is in the affirma-

tive, notice that if the value of z (given v) or v (given z) is too high, the problem doesnot have a solution, since the iso-profit line will lie everywhere above the boundary ofthe incentive region. The borderline case is one where the two are tangent, i.e, whenthe points A and B converge to each other and the feasible set of the constrained max-imization problem described above becomes a singleton. The solution must then bethis single feasible point. Tangency of (11) and (10) (the latter holding with equality)implies that δF

′(L) = 1 + r implying L < L∗ since δ < 1 and F is concave. There iscredit rationing if z (or v) is sufficiently high. Since the solution is continuous in z (orv), and given the comparative static properties of the corner solution, it follows thatthere will be credit rationing if either z or v (given the other) is above a critical value.

We summarize these observations in the following proposition:

Proposition 4 There is credit rationing if z, the lender’s profit (given v), or v, theborrower’s outside option (given z), is above some threshold value. If rationing ispresent, a further increase in the lender’s profit, or the borrower’s outside option,leads to further rationing (i.e, a reduction in the volume of credit) as well as a rise inthe interest rate.

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Documents

Credit Market Problems in Developing Countriesqed.econ.queensu.ca/pub/faculty/lloyd-ellis/econ835/...Irfan Aleem (1990) Informal sector = 75% of rural lending Mean Interest Rates: