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Why Intervene In Credit Markets? Armendariz – Morduch (Chap. 2)

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Presentation on theme: "Why Intervene In Credit Markets? Armendariz – Morduch (Chap. 2)"— Presentation transcript:

1 Why Intervene In Credit Markets? Armendariz – Morduch (Chap. 2)
Lecture 3 Week 2

2 Structure Of This Lecture
Rationale for Intervention (reviewed) Agency problems Limited Liability Adverse Selection Moral Hazard Conclusion: Is the problem solely about “more” information?

3 Rationale for Intervention
As argued in our last class, intervention can be justified: (1) On the grounds of Efficiency On the grounds of Distribution Example on efficiency: If dollars are borrowed to buy a sewing machine in the tailoring business, and it costs 20 cents per dollar to raise those funds, loans for machines should be given to those potential borrowers who can earn more than 20 cents per dollar

4 Introducing risk: Expected returns: 75% x % x 0 = 30 cents  borrower should be funded Can lenders charge 25% No! under perfect competition Adams (1984) argues that rural credit markets are competitive and therefore “informal credit” (high) interest rates do not compromise efficiency. There are other views: Singh (1968) would argue “high opportunity costs, Aleem (1990) would argue “monopolistic competition” in a segmented market, Robinson (2001) would argue microfinance is superior to moneylenders because “informational barriers” disappear with “scale”

5 Distribution: A debate
Trade off between efficiency and distribution (e. g., decline of socialist economies) In a world with limited financial markets not necessarily the case: Spreading access to “formal” financial services can both open opportunities for the poor and increase efficiency Note, however, that: Discrimination on the basis of race, gender, etc., can go against efficiency and against distribution, and Monopolistic practices might not always play against efficiency but very often against distribution The importance of pro-poor “impacts” of microfinance for improved efficiency and distribution remains a puzzle so far.

6 Agency Problems As seen in previous class, these are truly “informational problems”, which can be seen in three stages: (1) Prior to disbursing a loan (“adverse selection”) (2) Once loan has been granted (“moral hazard”) (3) Once investment returns have been realized Above agency costs accentuated when (a) individuals cannot offer seizable collateral, (b) legal enforcement mechanisms are weak, and (c) limited liability

7 Adverse selection: Example

8

9 A Numerical Example

10 Moral Hazard Ex Ante: As in the previous class Q: Implications of having “some valuable” collateral? Ex Post: As in the previous class Q: Implications of improving property rights and court systems? Agency costs can be potentially circumvented via peer monitoring as in GLJR

11 Is the problem solely about “information”?
Is linking to “local markets” a potential solution? How about employing well- informed “local agents”? How about “indirect links” to local markets?  Next Class: Armendariz-Morduch (Chapter 3)


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