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Why Intervene in Credit Markets

The document discusses problems that lenders face in developing country credit markets, including adverse selection, moral hazard, costly state verification, and enforcement issues. It notes that adverse selection, where lenders cannot distinguish safe and risky borrowers, accounts for about 60% of the problems. Moral hazard, where lenders do not know how loan funds will be used, accounts for 20%. Group lending is effective at overcoming these issues by reducing adverse selection and consequently moral hazard, costly state verification, and enforcement problems. Government intervention may be needed to help address market failures from these information problems.

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Christopher Colon
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63 views48 pages

Why Intervene in Credit Markets

The document discusses problems that lenders face in developing country credit markets, including adverse selection, moral hazard, costly state verification, and enforcement issues. It notes that adverse selection, where lenders cannot distinguish safe and risky borrowers, accounts for about 60% of the problems. Moral hazard, where lenders do not know how loan funds will be used, accounts for 20%. Group lending is effective at overcoming these issues by reducing adverse selection and consequently moral hazard, costly state verification, and enforcement problems. Government intervention may be needed to help address market failures from these information problems.

Uploaded by

Christopher Colon
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 48

2.

Why Intervene in
Credit Markets?
The Lending Problem:
● Why is lending difficult in developing
countries (LDCs) ?

● Microeconomics Angle

● Loan Transaction Different than other


Transactions:
Problems Lenders Face:
● Banks: ● Borrowers:
Agency Problems:
Lender and a borrower write up a loan contract.
● Principal-Agent Analysis
When one party wants another party to do a task that the
other party does not want to do ?
How do we write up these contracts ?
● Principal - Lender
● Agent – Borrower
Shareholder : Principal
Manager : Agent
● Limited Liability (borrowers cannot repay more than
their stated income) – no other ”punishment” possible
The Four Problems Identified:
● Adverse Selection* (AS): Lender does not
know if the borrower is safe/risky
● Moral Hazard* (MH) – Lender does not
know what the borrower does with the loan
money
● Costly State Verification Observation. (CSO).
For the lender to observe the output it is
costly.
● Enforcement ( E): lender has no recourse to
take borrower’s repayments.
Put on Time Line: Loans Unique
Draw a time line from t=0 to t=1
t=0 Loan is made
AS
MH : during the period from t=0 to t=1

CSO
E
t=1 Repayments are made
Fill the above with the 4 problems in sequence, which
would come first, which would be at end,….
CEO BASIX(MFI in India)- Vijay Mahajan
Additional Info
• CEO BASIX(MFI in India)- Vijay
Mahajan
said group lending’s effectiveness in
overcoming these four problems – if I
would weight:
60%: AS
20%: MH
20%: Others
Less AS – less MH – Less problem of CSO –
less problem of E : all connected
Adverse Selection
Hidden Information: Cannot tell
apart safe/risky
Adverse Selection: Example The
Story
• In rural areas
• There are two types of farmers: safe and risky.
• By safe we mean someone whose project which
will succeed for sure but a low output.
• By risky we mean someone whose project will
only succeed with a certain probability but if it
succeeds, it will receive a high output.
 E.g. Lottery
• Soon we will see a slide which shows an
example of safe and risky
Adverse Selection: The story continued
• Each borrower requires a loan of 100
rupees. The borrower currently works in
the labor market and earns 45 rupees (her
opportunity cost)
• The banks cost of lending is 40 rupees
(costs of operation).
• Everyone knows half the population is
safe, half is risky
• Bank’s profits in equilibrium are zero
(perfect competition or non-profit)
Introduce Adverse Selection
• Now the bank does not know who is safe or who
is risky so if someone comes through the door
the bank does not which “type” of borrower
walks through

• But it does know that the population has ½ safe


and ½ risky.
Adverse Selection:
• Numerical assumptions
– Bank’s cost of capital = 40 rupees
– Project requires 100 Rupees (loan amount)
– Reservation wage (opportunity cost)= 45
Rupees
– Half population is safe, half is risky

• Additional assumptions:
– Banks are competitive, profits go to zero.
Adverse Selection: Project Outcomes I
Type/Numbers Outcome Probability Expected =
(%) Average
Outcome

Safe 200 1(100) 200

Risky 267 .75 (75) 200


= .75(267)+.25(0
)
Questions to Consider I
• Is it socially efficient?
• What repayments would a competitive bank with perfect
information require? Interest rate ?
• What repayments would a competitive bank with
imperfect information require? Interest rate ?
• Will both borrow at this interest rate?
• Is outcome socially inefficient?
• Summary
Answers I: Socially
efficient?
Safe
200 – 100 – 40 = 60 > 45 (opportunity
cost)
Yes !

Risky
.75(267)+.25(0)-100-40 = 200 – 100 -
40=60>45
Yes !
Perfect Information: What should bank
charge ? (No AS)
R: gross repayments (repayments inclusive of the loan
amount)
Safe: this is a non-profit bank, so they will just charge the
cost of lending plus the loan amount, R(safe) = 100+40 =
140.

Risky:
Expected Repayments = cost of lending plus loan amount
.75(R(risky))+.25(0) = 140, .75(R(risky)) = 140
Divide by .75
Solve for R(risky) = 186.7
Connection between Repayments R and the
interest rate i
Interest rate = (repayments-loans)/loan
amount

Safe: (140-100)/100 = 40 %

Risky: (186.7-100)/100 = 86.7 %

So each repays according their risk level, or


the interest rate is “risk adjusted”
Imperfect Information, i.e. AS, what should bank charge on
its’ Repayments?

½ safe, ½ risky
Expected repayments based on a “fictional” average person
.5( R)(1)+.5( R)(.75)

Because it is non-profit, the expected repayments = costs


of the loan (including the principal) = 100+40.
.5( R)(1)+.5( R)(.75) = 140
.5R+.375R = 140
.875R=140
Divide by .875 = R = 160
Now both safe and risky receive this contract.
Who will accept the contract ?
Safe ?
Outcome - repayments
200 – 160 = 40 > 45 x
Safe will not accept this contract.
Risky ?
.75(267-160)+.25(0)= 80.25 > 45
Risky will accept this contract.
But now everyone knows that only risky are left,
so what happens ? To be continued…
Quiz
• Write as before = 10 minutes
• Please be active in class when you are taking the quiz – I
cannot follow bathroom breaks or other reasons for not
taking the random quiz
• You. May consult reading and notes but please do not
communicate with anyone
• We will discuss the article after the quiz
• Quiz on “Unpacking” 501 in module week 3
Adverse Selection: Example II: SAME
ASSUMPTIONS
• Numerical assumptions
– Lender’s cost of capital= 40 dollars/100
dollars
– Project requires $100
– Reservation wage (opportunity cost)= $45
– Half population is safe, half is risky
• Additional assumptions:

– Banks are competitive, profits go to zero.


Adverse Selection: Project Outcome II
Type/Numbers Outcome Probability Expected
(%) Outcome

Safe 200 1(100) 200

Risky 222 .9 (90) 200


Questions to Consider II
(OYO)
• Is it socially profitable?
• What repayments would a competitive bank with
perfect information require ? Interest rates ?
• What repayments would a competitive bank with
imperfect information require ?
• Will both borrow at these repayments ?
• Is it inefficient?
Answers II
Moral Hazard
Hidden Action – cannot find
choice borrower makes
Moral Hazard: What exactly ?
● Riskier Projects

● Diversion from Production to Consumption

● Low Effort - Shirking


Ex- ante Moral Hazard:
● Not Shirk: Y with probability 1
● Shirk: Y with probability p and 0 with
probability (1-p).
● Cost of effort: c
● Repayments: R
● Not shirking equation:
● Puts bound on R:
● Inefficiency?
● With Collateral
Moral Hazard: Summary
● Raising interest rates leads to problems:
○ Riskier projects
○ May divert production to consumption.
● Collateral alleviates moral hazard problem.
● In absence of collateral: does microfinance
provide a substitute?
Implications for Market of
Information Problems:
● Banks—raise interest rates?
● Profit maximization vs. market failure
● Dual function of interest rates:
○ Equate supply and demand
○ Ration quality of applicants
● Market Failure
On a graph
Missing Institutions/
Infrastructure:
● Adverse Selection

● Moral Hazard

● Costly State Verification

● Enforcement
● Can Gov’t Intervention Help here ?
Summary
• Microfinance Overview
• Finance should go the poor. Why doesn’t
it ?
• Bank-Borrower: Micro Issues
• Adverse Selection can lead to market
failure
• Moral Hazard can lead to market failure
Examples of CSV and E
• CSV. How does TAMU parking monitor
violators ?

• E. How does TAMU parking enforce


payment ?
CSV (Costly State
Verification)
• If Verify, can take real output of borrower
(assume reservation value = 0)

Assume output Ῡ with probability p


Output y with probability (1-p)

Where Ῡ > L > y


Verification costs C for Bank
Very high C  No contract
CSV (with contract possible)
Not high C  Contract possible but …
Will Bank verify at all output levels ?
NO
- only in one case.
1. If borrower gets Ῡ will she claim she got
y?
2.If borrower gets y will she claim she got
Ῡ?
CSV (with contract possible)
- Bank saves on observation costs
In a simple 2 output example, that means it
verifies with probability:

And expected verification costs are:


Enforcement (Ex post Moral
Hazard):
● Borrower’s side.

● “ Take the money and run.”

● What is needed?
Summary
• Costly State Verification (CSV) can lead to
market failure

• Enforcement (E) can lead to market


failure
Alternative Lending Solution
?
But remember the constraints

- No collateral
- Small loans
- No complementary institutions including
credit scores
- AS, MH, CSV, E all possible

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