Credit Markets part I

Development and Transition II Tbilisi, 2008

Demand for credit

There are several reasons why credit markets are 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 the existence of a substantial lag between the moment inputs have to be paid and sales generate money inflows; There is also demand for credit in order to smooth consumption or to cope with unforeseen negative shocks (consumption credit).

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 in monitoring :
True purpose of loan; Moral hazard associated with limited liability (choice of riskier project by borrower) in presence of uncertainty.

to reduce the risk of default banks ask for a collateral before advancing a loan. This means that formal credit becomes often an unfeasible option for poor borrowers (who can provide forms of collateral not accepted by formal lenders).

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 are not acceptable for formal lenders.

Some characteristics of rural credit markets

Informational constraints (use and repayment decision depending on characteristics of borrowers); Segmentation (personalized credit relationships take time to build up outsiders have more problems getting funds); Interlinkages between credit transactions and other activities of the moneylender and of the borrower; Interest rate variation (related to segmentation: interest rates differ by geographical location, source of funds, characteristics of borrower not always higher because of interlinkages); Rationing (existence of upper limits on how much a borrower receives from a lender at the going rate of interest); Exclusivity (moneylenders typically dislike situations in which their borrowers are borrowing also from other sources).

Theories of informal credit markets

Lenders monopoly: the very high interest rates that are sometimes observed may reflect the fact that the lender has exclusive monopoly power over his clients and can therefore charge a much higher price for loans than his opportunity cost. Problems:
Empirically we dont have evidence of the existence of complete monopoly (at best local monopoly); Theoretically, a high explicit interest rate is not always the best way to maximize profits (especially when interlinkages are present).

Theories of informal credit markets, cont.

Lenders risk hypothesis: lenders may be earning only enough to cover their opportunity cost. The higher interest rates may then be just the consequence of the substantial risk of default characterizing the rural credit markets. Types of default:
Involuntary; Strategic.

In this model the relation between i (interest rate charged from moneylender) and p (probability of receiving capital and interests back) is the following (r represents the opportunity cost): i=[(1+r)/p]-1 The informal interest rates will become higher the higher the probability of default (lower p). This takes us to study how do lenders manipulate and lower the default risk (potential default may be important, but actual default rates appear to be low).

Theories of informal credit markets, cont.

The lenders risk hypothesis however does not take into account the fact that the probability of default is most likely dependent from the amount to be repaid. Larger amounts to be repaid may lead to a greater risk of default. 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 may affect the chances of repayment We can extend this line of reasoning also to the kind of use to which the loan will be put (e.g. loan to migrate to the city or to invest and reduce future need for credit). In presence of strategic default, the most likely use of loans will be for working capital or consumption purposes (less for fixed investment reducing future needs).

Theories of informal credit markets, 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 is mainly 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 the additional advantage of covering the lender against involuntary default as well. However, if lender values the collateral MUCH MORE than the borrower, this may lead to excessively high rates of default (as the lender may design the contract in such a way that it would make default the best option for the borrower). Lets see this using a very simple model.

Theories of informal credit markets, cont.

Lets consider the case of a small landowner borrowing 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 VS while the value of the plot of land for the big landowner is VB. The borrower will prefer to return the loan if L(1+i)<VS+F. The lender will prefer to have his money back if L(1+i)> VB.

Theories of informal credit markets, cont.

Loan repayment is in the interest of both parties only if VB< Vs+F If the opposite (VB> Vs+F) is true the lender would prefer the borrower to default. A possible mean of achieving this goal is to drive up the interest rate so that the borrower has an incentive to default. This might help explaining the existence of land inequalities in poor societies. This analysis works much better for consumption loans than production loans, as consumption loans are usually characterized by a lower elasticity with respect to the interest rate (e.g. illness in the family). This is one possible explanation of why interest rates may be high for some types of credit transactions but not for others.

Default and credit rationing

Credit rationing: situation in which at the going rate of interest in the credit transaction the borrower would like to borrow more, but is not permitted to by the lender.
Interest rate

Figure 1

LS

LD

Loans

Default and credit rationing, cont.

The possibility of default is intimately tied to the existence of credit rationing. This can be shown using a simple model. We assume that a moneylender wishes to maximize the rate of return on his funds. We also assume that, if the interest rate becomes too high [such that the expected farmers surplus will go below a given value A alternative source of working capital] the farmer will borrow from another source. This can be written as:
f(L)-L(1+i)A Participation constraint

Default and credit rationing, cont.

Output, Costs, Profits
Production Function f(L)

L(1+i*)

Figure 2

L*

Loan size

Default and credit rationing, cont.

When we introduce the potential default, another constraint has to be taken into account. If the farmer defaults, he will not be able to borrow from the lender anymore and will be forced to borrow from alternative sources, gaining A from that moment onwards. Assuming his time horizon is of N periods, his choice 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

Default and credit rationing, cont.

The no-default constraint is tighter than the participation constraint; The difference between the two cases will be larger (smaller) when N becomes smaller (larger). It is evident that if N becomes 1, no loans will be returned, so no loan will be advanced, while we go back to the previous case with N very large; We can see graphically how introducing this new constraint affects the equilibrium.

Default and credit rationing, cont.

Output, Costs, Profits Modified cost line
Production Function f(L)

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

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

A
L(1+i**)

Figure 3
If L or i were larger, then the no-default constraint would fail L** optimal size of the loan for the moneylender

L**

L^

Loan size

Default and credit rationing, cont.

At the going interest i**, the borrower would like to borrow more. However, the moneylender cannot increase the interest rate nor expand the loan (at the going interest rate) without increasing the likelihood of a default. This is because a higher loan or higher interest rates increase the returns associated to a default.

Informational asymmetries and credit rationing

Lending risk may vary significantly from borrower to borrower (individual characteristics, landholdings, access to irrigation, type of crop, etc.) When the factors affecting risk are observable, the lender can select his clients and charge higher rates for higherrisk clients. However, when the lender is not able to distinguish between high and low-risk clients, the interest rate affects the mix of clients that are attracted and, consequently, the probability of default. In this case we might have a situation in which, at the going interest rate, there is an excess demand for loans that would 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.

Informal asymmetries and credit rationing: an example

Two types of potential customers: safe type and risky 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 only with probability p. With probability 1-p he gets 0. If the lender can finance only one project, should he increase the interest rate in order to maximize his expected profits? Not necessarily. In fact, the safe type customer would be willing to take the loan only if is=R/(L-1), while the risky type would be willing to pay ir=R/L-1 ir > is

Informal asymmetries and credit rationing: an example, cont.

If the lender applies is or below, both types of customers 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 is to ir) The expected of the lender in the two cases would be: r=p(1+ir)L-L s=1/2 isL+1/2[p(1+is)L-L] The lender will be reluctant to charge the higher interest rate when s>r.

Informal asymmetries and credit rationing: an example, cont.

Once the probability of repayment, p goes below a certain threshold, the lender will not raise his interest rate to ir (that would attract only the risky type) and will prefer instead to charge is and take the 50-50 chance of getting a safe customer. Of course, in this case one of the two customers will not receive the loan even though he would be willing to pay the going interest rate we have rationing. This time the cause of rationing is the fact that the higher interest rate would drive away the safe borrower, and the higher possible return would not be enough to compensate for the higher probability of default.

Default and enforcement

The borrowers dealings with the moneylender must yield him a greater profit than he could get elsewhere by defaulting 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 profits incase of no-default and A represents the profits associated with the alternative source of financing. The probability of default tends to increase as the borrower gives less weight to the potential future consequences of a default (has lower N time horizon) or as the profits associated with the alternative source of financing (A) increase the lender will be able to charge higher rates without risk of default only if N is large enough or if A is small (getting the loan from alternative sources is costly).

Default and enforcement, cont.

How can lenders reduce the probability of default? By making it more costly for the borrower to get a new loan once he has defaulted, for example by building a system of reputations. This requires, however, the rapid spread of default information, which is not always a reasonable postulate. As a matter of fact the way information is distributed evolves with the evolution of a society. And we might think at this as following a U pattern:
In traditional village societies with limited mobility, community networks are very strong and information circulates rapidly. At the other extreme, industrialized countries, credit histories are tracked on computer networks. Between these two extremes, we have societies in which mobility is increasing and traditional ties fall apart - together with informal information networks while formal networks have not been fully in place.

Default and enforcement, cont.

In situation where information about the previous behaviour of borrowers are not easily available, lenders have two sorts of reactions:
Approaching new potential borrowers very carefully or not at all (Ray, box page 559); Devoting a lot of effort and money checking the new borrowers credentials (past history) as this information might help establishing whether the borrower is an intrinsically bad prospect.

Collecting information about past history, however is worth only if we have two types of potential borrowers: cheaters and opportunists. If defaults come only from poorly specified contracts and not from the presence of cheaters, than there is no useful information to be found in the borrowers past history. On the other side, if we have no cheaters and there is no screening, the whole system will fall apart and no loans will be granted.

Default and enforcement, cont.

So screening efforts by a lender have large positive externalities on other lenders as they increase the cost of default for their borrowers. Unfortunately, as it happens in presence of positive externalities, the lenders do not take into account the existence of the externality and devote time and resources to screening only if they think this benefits them (as in the case when there are indeed some borrowers who are intrinsically bad risks). What is interesting is that, in this case, the credit market can work exactly because a market failure (lack of information about intrinsic types) helps solving another kind of information failure (lack of information on past defaults) by giving lenders an incentive to screen borrowers (collecting information or providing small test loans at the beginning of the relationship).

Interlinked transactions
In developing countries it is common to find loan transactions linked with dealings in some other market, such as the market for labor, land, or crop output. To the extent that the lender can directly benefit from the assets owned by the borrower, this makes credit transactions easier to enforce. It does appear that in the event of coincident occupations, the interlinking moneylender has an edge over other moneylenders in credit dealings. In fact, in many parts of developing world the pure moneylender figure is disappearing.

Interlinked transactions, cont.

There are several reasons why interlinkage is an observed mode of credit transactions:
Hidden interest: in some societies the explicit charging of interest is forbidden or shunned e.g. in Islamic societies under the Shaariat law. In these cases the loan results as interest-free and the interest is paid in secondary form; Interlinkages and information: thanks to an interlinked bargain, the lender can dispense with some of the costs of keeping track of the activities of the borrower (e.g. trader with crops and landlord with labor); Interlinkages and enforcement: used sometimes to prevent strategic default (one carrot used as two sticks e.g. landlord and tenant/borrower. Surplus to ensure effort now also to prevent default).

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 divided between lender and borrower. We are going to analyse two cases.
Loan repayment in labor; Loan repayment in output;

Loan repayment in labor

(Example of consumption smoothing)
Peak consumption
Higher interest (less slack consumption)

Peak consumption

Lower wage

Lower interest

Lower wage

W W* Risk-free interest rate

W B A W* L(1+i) L(1+i*)

A
L(1+i) B C L(1+i*)

Slack consumption

Slack consumption

Lenders return from a contract (w*, i*)

Loan repayment in labor, cont.

W A

W*

L(1+i)
B W C Peak consumption C U

If the lender can find a different 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 the size of the loan (L>L) because i is now = to the true opportunity cost for the lender.

L(1+i*) L L Slack consumption

Loan repayment in labor, cont.

W A A L(1+i*) B In this (second) case, the contract maximizing lenders utility while keeping constant the borrowers utility is leading to a surplus AC>AC.

W
W* C C U

L(1+i)

The result is optimal as there is no more distortion in the size of the loan (L<L) because i is now = to the true opportunity cost for the lender.

Peak consumption

L Slack consumption

Loan repayment in ouput

(Financing working capital)
If the borrower could borrow directly at the same opportunity cost of the lender/trader, he/she Production function would ask for a loan of size L

Value of output

B Real cost line

S C Opportunity cost line D

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*<L
Profits (BC) will be lower than in the optimal case (S). The only way to reap the additional surplus for the lender is by charging i and paying p< market price, reducing marginal cost of production and the price in the same proportion so that the ratio remains unchange relative to p/(1+i).

L*

Loans

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 combined operation and set t such that tS=A (where A is profit the borrower 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<p and i<i. Now, if the borrower tries to maximize profits, he will not change the quantity of L he demands. The borrower will still earn A (outside option) while the lender will earn S-A. In this case the interlinked contract is optimal and involves lower buying price coupled with a lower interest rate (lower even than the true opportunity cost for the lender).

Alternative credit policies

The needs of rural credit cannot be adequately served with the use of large financial institutions such as commercial banks, mainly because of the micro information needed for these operations. In response to this observation one can adopt two kinds of policies:
1. using the informal lenders to grant and recover loans from small borrowers creating vertical formal-informal links and expanding formal credit to informal lenders; 2. Design credit organizations at the microlevel that will take advantage of local information in innovative ways.

Alternative credit policies: vertical formal-informal links

Expansion of formal credit to informal lenders (landowners, traders, cooperatives, etc.) instead of attempting to displace one system by the other. Does this lead to increased competition between lenders and better conditions for borrowers? Not necessarily, because of:
Costs of monitoring (increased number of outside options lower cost of default for the borrower increased administrative/monitoring costs also the equilibrium interest rate might increase); Collusion (if the relation between competing lenders can be described as a strategically sustained cooperative gain there are several reasons easier to detect deviations if scale of operations increases, larger losses in case of retaliation, potentially diminishing marginal gains to think collusion may actually increase); Differential information (increased siphoning off of best borrowers may drive out of the market the lenders with less information).

Alternative credit policies: microfinance

Another possibility is that institutional lenders mimic and try to exploit some of the features of informal lending. For example acting both as lender 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 may be 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 Grameen Bank in Bangladesh.

The Grameen style lending

1. These loans are intended for clients too poor to meet the wealth requirements of the formal banking (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 to each member of their group; 5. Joint liability of the group members is the only guarantee on the loan (no collateral). 6. In the event of default, no group member is allowed to borrow again. [This gives an incentive to the members of the group to monitor (and to put pressure on) each other in a way that would be impossible for the lender.]

The Grameen style lending, cont.

The literature usually identifies three main advantages of group lending:

Reduction of transaction costs (direct costs of lending vary inversely 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 and organizational inputs they need; Repayment rates are more favorable in group lending.

These benefits are due mainly to positive assortative matching (a form of self-selection) and peer pressure. This assumes that borrowers have more information about each other 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 the market (safe borrowers would not accept them in their group); 2) there will be pressure for peer monitoring to lower the level of project riskiness (as there is joint liability).

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 socialintermediation etc.), especially to women (Berenbach and Guzman, 1993).

There are also potential drawbacks associated with group lending:

Increases the incentives to generalized default when one member incurs into genuine difficulties. This however does not affect the Grameen style lendings as loans are given sequencially; Peer monitoring may lead to a socially inefficient (too low) level of riskiness (and profitability) of the projects adopted. Group-based schemes may lack flexibility worstperforming member slowing down the group.

Evaluation of microcredit programs

Several studies have analyzed the effectivenes of microcredit programs, particularly the case of the Grameen Bank. Analysing a microcredit program however is complex, for several reasons: First of all, microcredit programs can be judged along several dimensions (sometimes conflicting with each other).For example: Sustainability vs. outreach (Snow and Buss, 2001)

Sustainability: earning sufficient revenues to cover all costs, mobilize local savings and involve its members in governance. This assures the institution is not vulnerable to the withdrawal of donor support. Outreach: getting help to the poor. If doing it as soon as possible is the top priority, rapid outreach desirable. This is only possible if it is available a cash flow sufficient to increase the loan portfolio. As generating the cash needed for expansion from operations alone is difficult in microcredit programs, donor capital is required.

Evaluation of microcredit programs, cont.

Secondly, even if we focus on the capacity of the programs to improve the condition of the poor (outreach), the analysis is made more complex by the fact that the evaluation requires to compare the final outcome (in time T) NOT with the situation of the beneficiaries ex-ante (in time 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 the situation of the participants before entering the program may lead to overestimates (selection of good borrowers) or underestimate (targeting the poor maybe with worse unobservable characteristics) the effectiveness of the program. Moreover, analyzing a microcredit program requires taking into account of both pecuniary and non pecuniary aspects.

Lessons:
There is at least a study (Pitt and Khandker (1996), for example) who managed to show that the Grameen Bank was effective in raising household income of participants vis--vis non participants (even without considering non monetary aspects). Of course there has been a number of cases in which microcredit programs have been implemented (see Hassan, 2002 and Snow and Buss, 2001 for some references), apart from the case of the Grameen case. In some of these cases microcredit programs were successful while in other they were not. This leads us to the conclusion that microcredit programs have to be tailored to the needs of the countries where they are implemented to be effective.

Lessons, cont.

Risks extend beyond merely wasting resources. Other potential risks involve (Snow and Buss, 2001):
microcredit lending being harmful to borrowers (e.g. potential debt trap); new aid dependence, different from the dependence on large project aid countries experienced in the 1960s and 1970s, but still damaging; at least some microcredit programs distort capital markets as other interventions. Microcredit programs may absorb resources needed for education and infrastructure development.

To avoid waste of resources or worse, governments and donors, ought to have specific (and explicit) goals for microcredit programs. This will help to measure and evaluate correctly their outcomes and to improve them.