Credit Markets1.ppt

8/13/2019 Credit Markets1.ppt

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Credit Marketspart I

Development and Transition II

Tbilisi, 2008


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Demand for credit

There are several reasons why credit marketsare important for development. Among these: Capital is required for new startups or for substantial

expansion of existing production lines (market for

fixed capital); It is necessary to finance the ongoing production

activity (market for working capital), because of theexistence of a substantial lag between the momentinputs have to be paid and sales generate moneyinflows;

There is also demand for credit in order to smoothconsumption or to cope with unforeseen negativeshocks (consumption credit).


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Who provides credit? (1)

Institutional/formal lenders (government banks,commercial banks, credit bureaus, etc.)

Main problem: Lack of personal knowledge about characteristics and

activities of the borrowers leads to a problem inmonitoring :

True purpose of loan;

Moral hazard associated with limited liability (choice of riskierproject by borrower) in presence of uncertainty.

to reduce the risk of default banks ask for a collateralbefore advancing a loan. This means that formalcredit becomes often an unfeasible option for poorborrowers (who can provide forms of collateral notaccepted by formal lenders).


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Who provides credit? (2)

Informal lenders (e.g. landlord,

shopkeeper, trader, but also cooperatives,

credit unions, self-help organizations)

Better information regarding characteristics

and activities of borrowers (closer to

borrowers and interacting with them);

willing to accept collateral in forms that arenot acceptable for formal lenders.


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Theories of informal credit markets

Lenders monopoly: the very high interest ratesthat are sometimes observed may reflect the factthat the lender has exclusive monopoly powerover his clients and can therefore charge amuch higher price for loans than his opportunitycost.

Problems: Empirically we dont have evidence of the existence

of complete monopoly (at best local monopoly);

Theoretically, a high explicitinterest rate is not alwaysthe best way to maximize profits (especially wheninterlinkages are present).


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Theories of informal credit markets,

cont. Lenders risk hypothesis: lenders may be earning only

enough to cover their opportunity cost. The higher interestrates may then be just the consequence of the substantialrisk of default characterizing the rural credit markets.

Types of default: Involuntary;

Strategic.

In this model the relation between i (interest rate chargedfrom moneylender) and p (probability of receiving capitaland interests back) is the following (r represents theopportunity cost):

i=[(1+r)/p]-1The informal interest rates will become higher the higher the

probability of default (lower p). This takes us to study how dolenders manipulate and lower the default risk (potentialdefault may be important, but actual default rates appear to

be low).


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cont. The lenders risk hypothesis however does not take into

account the fact thatthe probability of default is mostlikely dependent from the amount to be repaid. Largeramounts to be repaid may lead to a greater risk ofdefault.

large loans will have lower probability to be made;in some cases the loan will not be given irrespective of

the interest rate premium, as the premium itself mayaffect the chances of repayment

We can extend this line of reasoning also to the kind ofuse to which the loan will be put (e.g. loan to migrate tothe city or to invest and reduce future need for credit).

In presence of strategic default, the most likely use ofloans will be for working capital or consumptionpurposes (less for fixed investment reducing future

needs).


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cont. Default and collateral:the fear of default creates the

tendency to ask for collateral (land, use rights to output,labor, etc.), whenever this is possible. The collateral ismainly of two types:

Valued highly from both the lender and the borrower; Valued highly by the borrower but not from the lender.

Collateral valued highly by both parties has theadditional advantage of covering the lender againstinvoluntary default as well.

However,if lender values the collateral MUCH MOREthan the borrower, this may lead to excessively highrates of default(as the lender may design the contract insuch a way that it would make default the best option forthe borrower). Lets see this using a very simple model.


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cont.

Lets consider the case of a small landownerborrowing from a big landowner and giving as

collateral a plot of land adjacent to the land of

the big landowner.

The small landowners evaluation of the value of

the plot of land is VSwhile the value of the plot of

land for the big landowner is VB.

The borrower will prefer to return the loan ifL(1+i) VB.


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cont.

Loan repayment is in the interest of both parties only ifVB< Vs+F

If the opposite (VB> Vs+F) is true the lender wouldprefer the borrower to default.

A possible mean of achieving this goal is to drive up theinterest rate so that the borrower has an incentive todefault.

This might help explaining the existence of landinequalities in poor societies.

This analysis works much better for consumption loansthan production loans, as consumption loans are usuallycharacterized by a lower elasticity with respect to theinterest rate (e.g. illness in the family). This is one possibleexplanation of why interest rates may be high for some

types of credit transactions but not for others.


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Default and credit rationing

Credit rationing:situation in whichat the going rate ofinterest in the credit transactionthe borrower would like

to borrow more, but is not permitted to by the lender.

Loans

Interest

rate

LDLS

Figure 1


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Default and credit rationing, cont.

The possibility of default is intimately tied to theexistence of credit rationing.

This can be shown using a simple model.

We assume that a moneylender wishes tomaximize the rate of return on his funds.

We also assume that, if the interest rate becomestoo high [such that the expected farmers surpluswill go below a given value Aalternative sourceof working capital] the farmer will borrow from

another source. This can be written as:

f(L)-L(1+i)A Participation constraint


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Production Function f(L)

L(1+i*)

Loan size

O

utput,Costs,

Profits

L*

A

Figure 2


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When we introduce the potential default, anotherconstraint has to be taken into account.

If the farmer defaults, he will not be able to borrowfrom the lender anymore and will be forced to

borrow from alternative sources, gaining A fromthat moment onwards.

Assuming his time horizon is of N periods, hischoice will be between earning N[f(L)-L(1+i)]

without default or f(L)+(N-1)A for default NOT to occur we must have:

N[f(L)-L(1+i)] f(L)+(N-1)A

which becomes f(L)-(N/N-1)L(1+i)A


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Production Function f(L)

L(1+i**)

Loan size

O

utput,Costs,

Profits

L**

A

Figure 3

[N/(N-1)]L(1+i**)

L^

If L or i were larger, then the no-default

constraint would fail L** optimal size of

the loan for the moneylender

N/(N-1)(1+i**) is

the marginal

product of the loan

for the

moneylender

1+i** is the

marginal cost of

the loan faced by

the borrower

Modified cost line


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I f ti l t i d


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Informational asymmetries and

credit rationing

Lending risk may vary significantly from borrower toborrower (individual characteristics, landholdings, access toirrigation, type of crop, etc.)

When the factors affecting risk are observable, the lendercan select his clients and charge higher rates for higher-

risk clients. However, when the lender is not able to distinguish

between high and low-risk clients, the interest rate affectsthe mix of clients that are attracted and, consequently, theprobability of default.

In this case we might have a situation in which, at the goinginterest rate, there is an excess demand for loans thatwould make it possible for lenders to raise interest rates.However, lenders would not raise interest rates for fear of

attracting too many high-risk customers.

I f l t i d dit


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Informal asymmetries and credit

rationing: an example

Two types of potential customers: safe type andrisky type;

Both need a loan of the same size, L;

The safe type can always obtain a return of R>L;

The risky type instead can obtain R>R>L but onlywith probability p. With probability 1-p he gets 0.

If the lender can finance only one project, shouldhe increase the interest rate in order to maximizehis expected profits? Not necessarily.

In fact, the safe type customer would be willing totake the loan only if is=R/(L-1), while the risky typewould be willing to pay i

r

=R/L-1 ir

> is

I f l t i d dit


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rationing: an example, cont.

If the lender applies isor below, both types ofcustomers will apply, while if he applies a rate

larger than is, only the risky type will apply

(knowing this, once moved away from is, the lender

should then move from isto ir)

The expected of the lender in the two cases would

be:

r=p(1+ir)L-Ls=1/2 isL+1/2[p(1+is)L-L]

The lender will be reluctant to charge the higher

interest rate when s

>r

.

I f l t i d dit


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rationing: an example, cont.

Once the probability of repayment, p goes below acertain threshold, the lender will not raise hisinterest rate to ir(that would attract only the riskytype) and will prefer instead to charge isand takethe 50-50 chance of getting a safe customer.

Of course, in this case one of the two customerswill not receive the loan even though he would bewilling to pay the going interest rate we haverationing.

This time the cause of rationing is the fact that thehigher interest rate would drive away the safeborrower, and the higher possible return would notbe enough to compensate for the higher probabilityof default.


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Default and enforcement

The borrowers dealings with the moneylender must yieldhim a greater profit than he could get elsewhere bydefaulting in order for him not to default.

Algebraically:

f(L**)-(1+i**)L**>f(L**)-(N/N-1)(1+i**)L**=A

Where f(L**)-(1+i**)L** represent the borrowers profitsincase of no-default and A represents the profitsassociated with the alternative source of financing.

The probability of default tends to increase as theborrower gives less weight to the potential future

consequences of a default (has lower Ntime horizon)or as the profits associated with the alternative source offinancing (A) increase the lender will be able tocharge higher rates without risk of default only if N islarge enough or if A is small (getting the loan fromalternative sources is costly).


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Default and enforcement, cont. How can lenders reduce the probability of default? By

making it more costly for the borrower to get a new loanonce he has defaulted, for example by building a system ofreputations.

This requires, however, the rapid spread of defaultinformation, which is not always a reasonable postulate.

As a matter of fact the way information is distributedevolves with the evolution of a society. And we might thinkat this as following a U pattern:

In traditional village societies with limited mobility, communitynetworks are very strong and information circulates rapidly.

At the other extreme, industrialized countries, credit historiesare tracked on computer networks.

Between these two extremes, we have societies in whichmobility is increasing and traditional ties fall apart - togetherwith informal information networkswhile formal networkshave not been fully in place.


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Default and enforcement, cont.

In situation where information about the previous behaviour ofborrowers are not easily available, lenders have two sorts ofreactions:

Approaching new potential borrowers very carefullyor not at all(Ray, box page 559);

Devoting a lot of effort and money checking the new borrowerscredentials (past history) as this information might helpestablishing whether the borrower is an intrinsicallybadprospect.

Collecting information about past history, however is worthonly if we have two types of potential borrowers: cheaters andopportunists. If defaults come only from poorly specified

contracts and not from the presence of cheaters, than there isno useful information to be found in the borrowers pasthistory.

On the other side, if we have no cheaters and there is noscreening, the whole system will fall apart and no loans will begranted.


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Default and enforcement, cont. So screening efforts by a lender have large positive

externalities on other lenders as they increase thecost of default for their borrowers. Unfortunately, as ithappens in presence of positive externalities, thelenders do not take into account the existence of theexternality and devote time and resources to

screening only if they think this benefits them (as inthe case when there are indeed some borrowers whoare intrinsically bad risks).

What is interesting is that, in this case, the creditmarket can work exactly because a market failure

(lack of information about intrinsic types) helps solvinganother kind of information failure (lack of informationon past defaults) by giving lenders an incentive toscreen borrowers (collecting information or providingsmall test loans at the beginning of the relationship).


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Interlinked transactions

In developing countries it is common to find loantransactions linked with dealings in some othermarket, such as the market for labor, land, orcrop output.

To the extent that the lender can directly benefitfrom the assets owned by the borrower, thismakes credit transactions easier to enforce.

It does appear that in the event of coincident

occupations, the interlinking moneylender hasan edge over other moneylenders in creditdealings. In fact, in many parts of developingworld the pure moneylender figure isdisappearing.


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Interlinked transactions, cont.

There are several reasons why interlinkage is anobserved mode of credit transactions: Hidden interest:in some societies the explicit charging

of interest is forbidden or shunnede.g. in Islamic

societies under the Shaariat law. In these cases the loanresults as interest-free and the interest is paid insecondary form;

Interlinkages and information:thanks to an interlinkedbargain, the lender can dispense with some of the costsof keeping track of the activities of the borrower (e.g.trader with crops and landlord with labor);

Interlinkages and enforcement:used sometimes toprevent strategic default (one carrot used as two sticks

e.g. landlord and tenant/borrower. Surplus to ensureeffort now also to prevent default).


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Interlinked transactions, cont.

Interlinkages and creation of efficient

surplus: interlinkages may arise also in

order to prevent distortions that lower the

total surplus available to be dividedbetween lender and borrower. We are

going to analyse two cases.

Loan repayment in labor; Loan repayment in output;


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Loan repayment in labor, cont.

Peakconsum

ption

Slack consumptionL

W

A

B

C

L(1+i*)

L(1+i)

W* A

C U

W

L

If the lender can find adifferent combination of w and

i keeping the borrower on the

same utility curve while

increasing his own utility, we

can say that he will have

found a contract that

dominates the previous one.In our case, the contract

maximizing lenders utility

while keeping constant the

borrowers utility is leading to

a surplus AC>AC.

The result is optimal as there

is no more distortion in thesize of the loan (L>L) because

i is now = to the true

opportunity cost for the lender.


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Loan repayment in labor, cont.

Peakconsum

ption

Slack consumptionL

W

A

B

C

L(1+i*)

L(1+i)

W*

A

CU

W

L

In this (second) case, the

contract maximizing lenders

utility while keeping constant

the borrowers utility is leading

to a surplus AC>AC.

The result is optimal as thereis no more distortion in the

size of the loan (L


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Loan repayment in ouput(Financing working capital)

S

B

C

D

L* L

Opportunity cost line

Real cost line

Production function

Loans

Valu

eofoutput

If the borrower could borrow

directly at the same opportunitycost of the lender/trader, he/she

would ask for a loan of size L

However, as this is not possible,

he/she will have to contact a lender.

Assuming the lender/trader chooses

a pure credit contract, he/she will

charge a higher interest rate

(between the opportunity cost and

the cost that would be paid by the

borrower on the market) and pay the

market price of rice. In this case,

however, the borrower would ask for

a loan of size L*


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Loan repayment in ouput, cont.(Financing working capital)

Algebraically, we can write the maximum surplus as:S=pQ-(1+i)L

If we impose a profits tax of t per dollar on the combinedoperation and set t such that tS=A (where A is profit theborrower makes financing working capital on the credit

market), we obtain:tS=ptQ-(1+i)tL

We can define then ppt and i such that 1+i=(1+i)t. p


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Alternative credit policies

The needs of rural credit cannot be adequatelyserved with the use of large financial institutionssuch as commercial banks, mainly because ofthe micro information needed for these

operations. In response to this observation one can adopttwo kinds of policies:

1. using the informal lenders to grant and recover loansfrom small borrowers creating vertical formal-informallinks and expanding formal credit to informal lenders;

2. Design credit organizations at the microlevel that willtake advantage of local information in innovative ways.


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Alternative credit policies:

microfinance

Another possibility is that institutional lendersmimic and try to exploit some of the features ofinformal lending. For example acting both aslender and as miller or moving from individual to

group lending. In fact, in cases when it is impossible for financial

institution to provide credit to an individual, it maybe possible for the same institution to give credit

to a group. The most famous example of an institution

engaged in group lending is that of the GrameenBank in Bangladesh.


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The Grameen style lending

1. These loans are intended for clients too poor tomeet the wealth requirements of the formalbanking (mostly women).

2. Loans are given to small groups of borrowers;

3. Requires borrowers to keep savings in the bank;

4. Borrowers are jointly liable for the loans granted toeach member of their group;

5. Joint liability of the group members is the onlyguarantee on the loan (no collateral).

6. In the event of default, no group member isallowed to borrow again. [This gives an incentiveto the members of the group to monitor (and to put

pressure on) each other in a way that would be

impossible for the lender.]


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The Grameen style lending, cont.

The literature usually identifies three main advantages of

group lending: Reduction of transaction costs (direct costs of lending varyinversely with the size of the loan);

Working in groups helps poor people having access to more credit(financial reason) and getting access to the training andorganizational inputs they need;

Repayment rates are more favorable in group lending. These benefits are due mainly topositive assortative

matching(a form of self-selection) and peer pressure. Thisassumes that borrowers have more information about eachother and are better at monitoring each others activities

than the lender could be. If this is true: 1) riskier borrowers could be driven out of themarket (safe borrowers would not accept them in theirgroup); 2) there will be pressure for peer monitoring tolower the level of project riskiness (as there is joint liability).


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The Grameen style lending, cont.

Moreover, group lending has been found to offer also

non-pecuniary returns (e.g. self-esteem, mutual trust,empowerment, self-discipline, encouraging social-intermediation etc.), especially to women (Berenbachand Guzman, 1993).

There are also potential drawbacks associated

with group lending: Increases the incentives to generalized default when

one member incurs into genuine difficulties. Thishowever does not affect the Grameen style lendingsas loans are given sequencially;

Peer monitoring may lead to a socially inefficient (toolow) level of riskiness (and profitability) of the projectsadopted.

Group-based schemes may lack flexibility worst-performing member slowing down the group.


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Evaluation of microcredit programs


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Evaluation of microcredit programs,cont.

Secondly, even if we focus on the capacity of the programsto improve the condition of the poor (outreach), theanalysis is made more complex by the fact that theevaluation requires to compare the final outcome (in timeT) NOT with the situation of the beneficiaries ex-ante (intime T-n), BUT with the situation of the same beneficiaries

in time T, had they not participated. There are reasons to believe that, failing to compare the

final outcome with its counterfactual, but just with thesituation of the participants before entering the programmay lead to overestimates (selection of good borrowers)

or underestimate (targeting the poor maybe with worseunobservable characteristics) the effectiveness of theprogram.

Moreover, analyzing a microcredit program requires takinginto account of both pecuniary and non pecuniary aspects.


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Lessons:

There is at least a study (Pitt and Khandker (1996), forexample) who managed to show that the Grameen Bankwas effective in raising household income of participantsvis--vis non participants (even without considering nonmonetary aspects).

Of course there has been a number of cases in whichmicrocredit programs have been implemented (seeHassan, 2002 and Snow and Buss, 2001 for somereferences), apart from the case of the Grameen case. In

some of these cases microcredit programs weresuccessful while in other they were not.

This leads us to the conclusion that microcredit programshave to be tailored to the needs of the countries wherethey are implemented to be effective.


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