CREDIT

Debraj Ray


a.
b.

Credit is taken to finance: Ongoing production (market for working capital). Shortfalls in consumption (market for consumption

credit).
c.

New ventures (market for fixed capital). Although fixed capital credit is of great importance in determining the overall growth of the economy, working capital and consumption credit are fundamental to our understanding of how an economy supports its poor and disadvantaged, specially agriculture. This chapter is based on the presumption that human beings are out to do the best for themselves and display no altruism whatsoever. Also assumes that credit markets are imperfect.

 a.

Two fundamental problems characterize credit markets: The problem of inability to repay (involuntary

default)*
b.

The problem of unwillingness to repay (strategic

default).*
Both these problems are outcomes of informational imperfections.

WHO PROVIDES RURAL CREDIT?

Institutional or formal lenders- government or commercial banks, credit bureaus, and so on.. Informal lenders- village moneylenders, landlords, traders, and shopkeepers.

1.

2.

Two considerations typically put formal lenders at a disadvantage relative to their informal counterparts: They lack information regarding the characteristics, history, or current activities of their clients. They cannot accept collateral in some nonmonetary forms, such as labor or output. One example of the informational problem is a limited liability situation, in which a borrower repays if successfully, but is otherwise limited by her resources to fully repay the loan. In such situations, a loan that cannot be properly monitored may be used in overly risky activities, because the borrower does not internalize the downside risk, which is borne by the bank.

INFORMAL (RURAL CREDIT) MARKETS CHARACTERISTICS:

1) 2)

3)

4)

5)

6)

Informational constraints (which create repayment problems ) Segmentation (in which lenders seem to deal with demarcated zones of borrowers) Interlinkage (in which lenders and borrowers are simultaneously transacting with each other on at least one other market, such as land or output) Interest-rate variation (across borrower types , loan purpose, or spatial dimensions) Credit rationing (a borrower may wish to borrow more at the going rate of interest in the transaction, but is not permitted to) Exclusivity (a borrower typically deals with one lender at a time).

THEORIES OF INFORMAL CREDIT MARKETS

1. Lenders monopoly:

One explanation for the very high rates of interest is that the lender has exclusive monopoly power over his opportunity cost(which is usually the competitive rate offered by formal-sector banks and urban credit markets). There are empirical and theoretical problems with this line of explanation. Aleems 1980-81 survey of the Chambar area in Sind, Pakistan, revealed that the often-imagined picture of a single village moneylender with monopoly power over clients in the village does not hold true in the Chambar context. But we can at best assume that lenders have local monopoly with limits. Also, monopoly power is not necessarily an explanation of high interest rates, at least of high explicit interest rates. From the point of view of efficient surplus generation, it is often better to pick up moneylending profits in forms other than interest.

2. The lenders risk hypothesis: In its extreme form, this hypothesis maintains that lenders earn no (ex ante) return on their money over and above their opportunity cost. However, as the story goes, there is substantial risk of default in rural credit markets: the borrower might default on interest payments and even part or all of the principal. The risk comes from many sources: Risk of involuntary default Risk of voluntary or strategic default In the simplest version of the theory, there is p - an exogenous probability of repayment on every dollar lent out. 1-p - probability of default. Competition between moneylenders drives the rural interest rate down to a point where each lender on the average earns zero expected profit.*

Consider a typical village moneylender in this competitive market. Let L- total amount of funds he lends out r- opportunity cost of funds for every moneylender i- interest rate charged in competitive equilibrium in the informal sector. Because only a fraction p of loans will be repaid, the moneylenders expected profit is p(1+i)L (1+r)L = 0 then,

When p=1, that is, when there is no default risk, we have i=r: informal interest rates are the same as formal-sector rates. For p<1, we have i>r: the informal rate is higher to cover the risk of default.

3. Default and fixed-capital loans The analysis in the earlier section is deficient in one serious respect. It is assumed that the default probability is independent of the amount to be repaid. Larger amounts to be paid may lead to a greater risk of default. This statement suggests that certain loans will not be given at all under any circumstances, irrespective of the interest rate premium, because the premium itself affects the chances of repayment. Likewise, large loans themselves raise the chances of default and will, therefore, not be made. Also, if the loan can be used by the borrower to permanently put himself in a situation in which he never has to borrow again, then such loans may not be forthcoming. In the presence of strategic default, the overwhelming provision of informal loans will be for working capital or consumption purposes , rather than for fixed investments that may permanently reduce the borrower's future need for credit.

4. Default and collateral The fear of default also creates a tendency for collateral, whenever this is a possible. Collateral may take many forms: Transfer of property rights while the loan is outstanding. Labor may be mortgaged. Fundamentally, collateral is of two types: 1. One in which both the lender and borrower value the collateral highly, and 2. another in which the borrower values the collateral highly, but the lender does not. Collateral that is valuable to both parties has the additional advantage that it covers a lender against involuntary default as well. For these types of collateral, credit may simply be a veil for acquiring collateral. Suppose a small farmer who is in need of a loan of size L, perhaps to tide over a family emergency approaches the

local large landowner. Suppose further that the landowner asks him to pledge the plot of land adjacent to that of him as collateral for the loan. Let i- interest rate charged on the loan L V- the value(monetary)that small farmer places on his land V- value that the big landowner attaches to the same plot of land F- monetary value of the loss to the farmer from the default, over and above the loss of his collateral.* When the time comes to return the loan, we can conceive two possibilities: The borrower may be in a state of involuntary default, in that case, he certainly loses the land. The borrower may contemplate willful default: in that case, the total loss to the borrower is V + F , whereas the gain is that he gets to keep the principal plus interest that he owed.

Thus the borrower will prefer to return the loan if L(1+i) < V + F ---------(1) Consider, now, the lenders preferences. He will prefer his money back if L(1+i)> V ---------(2) Combining (1) and (2), we may conclude that loan repayment is in interest of both the parties only if V < V + F ---------(3) that is, lenders valuation must not exceed the borrowers valuation by too much.* Suppose now that (3) does not hold, so that V > V + F. In this case, it follows that whenever the borrower prefers to repay the loan, the lender actually wants him not to do so!!! Thus the collateral that is of value to both lender and the borrower may result in credit transactions with excessive rates of defaults. The debt contract may be written so as to deliberately induce transfers of lands.

5. Default and credit rationing Credit rationing refers to a situation in which at the going rate of interest in the credit transaction, the borrower would like to borrow more money, but is not permitted by the lender. Except in very special cases, the notion of rationing makes no sense unless the price of the rationed commodity is specified. The possibility of default is intimately tied to the existence of credit rationing, as following simple model illustrates. Suppose that a moneylender wishes to allocate his available funds in a way that maximizes his rate of return on the funds. Imagine that there are a large number of potential farmers that he could lend to, each of whom use the loan as working capital to buy inputs for production. In diag-1,we display a production function for a typical farmer that converts working capital(L) into output.

Let us introduce the possibility of strategic default. Suppose that farmer can willingly default on the loan. Assume that the moneylender will never lend to him again. However, the farmer can always go for his next best alternative and guarantee himself a profit of A from the next date onward. Taking into account the borrowers mental time horizon: the extent to which the future concerns him when he makes current decisions, suppose that at each date, the farmer thinks N dates into the future and factors in the consequences of his current decisions on gains and losses in the coming N periods. Let f(L) describe the value of the output for every loan size L. As L increases, so does the value f(L).

The requirement that the farmer should want to participate at some interest rate i and some loan size L is just the statement that Let us call above equation the participation constraint.

Then, what the farmer gets over his entire mental horizon of N dates is the amount per date, multiplied by N:
If he decides to default, today he will get all of f(L) but from tomorrow onward, he is excluded by the above moneylender and so he can get only A per period. Thus the total profit over the N period mental horizon is

For default not to occur,

Rewriting ,we get

which looks like the participation constraint, except for the term N/(N-1) that multiplies the cost line. Because this term always exceeds 1, the new restriction is tighter and subsumes, the participation constraint. The above new restriction is called the no-default constraint. The shorter the mental horizon, the more difficult it is to meet the no-default constraint.*

At the optimum credit transaction, the moneylender will advance a loan of L**: the marginal product of the loan equals N/(N-1)(1+i**) and not the true marginal cost of the loan as faced by the borrower, which is 1+i**. It follows that we have credit rationing: the borrower would like to borrow an amount L^ in a competitive market where all contracts can be costlessly enforced. The moneylender would not react to such a situation by simply raising the interest rate or advancing a larger loan at a going interest rate because of the fear of sparking off a default. A higher loan increases the return to a defaulter by allowing him to pocket more money. A higher interest rate increases the return as well, by allowing the defaulter to save on the repayment of more interest. The moneylenders preferred contract therefore involves credit rationing.

6. Informational asymmetries and credit rationing Not all borrowers bear the same amount of risk. There are high-risk borrowers and there are low-risk borrowers.* Risk may be correlated with characteristics of the borrower that are observable to the lender. However, it may substantially depend on other qualities that are not observable (farming skills, quality of land etc.). Clients bear different risks that cannot be discerned by the lender, thus the interest rate now affects the mix of clients that are attracted (and hence, the average probability of default). This gives rise to a situation in which at prevailing rates, some people who want to obtain loans are unable to do so; however, lenders are unwilling to capitalize on the excess demand and raise interest rates for the fear that they will end up attracting too many high-risk customers.

Consider a moneylender who faces two types of potential customers: the safe type and the risky type. Each type of borrower needs a loan of (the same) size L to invest in some project. Suppose the safe type is always able to obtain a secure return of R (R>L) from the investment. On the other hand, the risky type is an uncertain prospect; he can obtain a higher return R` (where R`>R), but only with probability p. With probability 1-p, his investment backfires and he gets a return of 0. Suppose further that the moneylender has enough funds to lend to just one applicant and he can freely set the interest rate.* The safe borrowers net return is given by: thus highest acceptable rate for him is

For the second borrower, the expected return is:

Hence, the maximum rate he is willing to pay is

Because R` > R , we have i> i. The risky borrower is willing to pay a higher rate of interest than the safe borrower, and this interest rate is independent of his probability of success, p. His expected return depends only on the success state. If the lender charges i or below, both borrowers will apply for the loan. If the lender cannot tell them apart, he has to give the loan randomly. On the other hand, if a rate slightly

higher than i is charged, the first borrower drops out and excess demand for loan disappears. The lenders choice is then between the two interest rates i and i. Suppose the lender charges i . His expected profits are then given by

On the other hand, if the lender charges i he attracts each type of customer with probability . His expected profits are given by:

If > then the lender will be reluctant to charge the higher interest rate. Using the values of and and substituting the values of i and i, we obtain the condition

This condition tells us that if the high-risk type is sufficiently risky (lower p means a higher chance of default), then the lender will not raise his interest rate to i , thereby attracting the risky type. Instead he will stick to the lower level i and take the 50-50 chance of getting a safe customer. This will lead to credit rationing in equilibrium: out of two customers demanding a single available loan, only one will get it; the other will be disappointed.

7. Default and enforcement Repayment can be insured through dynamic threats and incentives. A defaulter switches to another source when the current lender refuses to deal with him any further. This fear forces the lender to offer the borrower some premium or surplus on the loan over and above his opportunities elsewhere. Apart from building repayment incentives into their credit transaction, the lenders can discipline borrowers with the help of a system of reputations. If a borrower defaults in his transactions with one lender, this may destroy his reputation in the market and mark him as bad risk. As a result, other lenders may be reluctant to lend him in the future. A lender will eagerly make a default public, and he will certainly want to make this willingness known in advance to the borrower.*

In the face of limited information about the past behavior of borrowers, lenders have two sorts of reactions: a. The first possibility is that they check out a new borrower with a great deal of wariness. The lender might expend effort and money to check the credentials of the borrower, to see that he is indeed a good risk. b. Lenders may wish to start small and increase the loan size if borrowers return the smaller loans. These small loans serve as indirect tests of the borrowers intrinsic honesty. The small loans are called testing loans.

ALTERNATIVE CREDIT POLICIES

There has been a growing realization that the needs of rural credit cannot be adequately served with the use of large financial institutions such as commercial banks. The microinformation that is required for these operations precludes efficient market coverage on the part of these large organizations. Two kinds of policies can arise: 1. Vertical formal-informal links Expansion of formal credit to informal lenders Large landowners or traders are in a much better position to put up the collateral: from point of view of banks, they are good credit risks. They then use the funds to cash in on their informational advantage in informal markets.* The expansion of formal sector credit to

these agents generates competition among them, and this hopefully improves the borrowing terms faced by individuals who fall outside the ambit of the formal credit system. Possible effects Do these schemes intensify competition among informal lenders? Theoretical analysis suggests that the answer is likely to be mixed. Reasons: 1. Cost of monitoring 2. Collusion 3. Differential information A bottom line All this is not to say that an expansion of credit from the formal sector is bound to fail, but the simplistic expectation that such expansion will invariably lower interest rates for small borrowers may not be automatically upheld.

2. Microfinance The Grameen Bank It is also possible for institutional lending to closely mimic and exploit some of the features of informal lending. For instance, it may be possible to design an innovative rural credit scheme in a rice-growing area in which a formalsector institution acts as a lender and a miller. The combined activity will permit the formal institution to accept rice output as repayment for loans. By mimicking the activities of a trader-moneylender, the formal institution may actually be able to carry out lending activities that reach small borrowers and are profitable at the same time. There are ways in which the information base of a community can be put to use by a cleverly constructed lending institution. Example: Grameen Bank of Bangladesh.*

Group lending and the use of information The central feature of the Grameen Banks lending policy is that in the event of a default, no group member is allowed to borrow again. The borrowers themselves have an incentive to use information to form groups, and this induces a form of self-selection that no individual-based banking scheme can mimic. Some of the specific implications: Positive assortative matching : Self-selection typically takes the form of positive assortative matching, where good credit risks come together. Group formation has the property that it can drive risky types out of the market, because some of the costs of their riskiness are borne by other borrowers instead of the bank alone. Peer monitoring: group lending has two effects: first, relative to individual borrowing, it increases the risk on any one borrower for a given level of project riskiness: this is cost. Second, it creates pressures for peer

monitoring to lower the level of project riskiness: this is the gain. Group members might be able to monitor and influence the choice of individual projects. Potential drawbacks: when one member of the group runs into genuine financial difficulties and defaults, it is a dominant strategy for other group members to default on their outstanding loans as well. The Grameen Bank avoids this problem by lending sequentially to group members. There may be excessive pressures to by group members to choose overly safe outcomes that are not socially optimal in terms of average probability. Group-based schemes may lack flexibility. In rapidly changing environment, the worst-performing member slows down the group as a whole.

Viability : The Grameen Bank lends to the poor. There are limits on the interest rate that it can charge without seriously affecting repayment capacity, and loan sizes are very small. There are cost of providing, tracking, and ensuring repayment of the loan, and these are fixed costs per borrower, so that small loan sizes raise these costs. Grameen has functioned under a significant amount of subsidy , both from foreign donors as well as from the Central Bank of Bangladesh.

Other microfinance institutions Bancosol in Bolivia lends to groups rather than individuals. The Bank Rakyat Indonesia(BRI) lends to individuals and ask for collateral.

Thank you