ECON60022 Development Microeconomics Lectures 6 & Tutorial 4: ‘Models on Rural Credit Markets’ Katsushi Imai Office Hours: Tuesday

2 0. Schedule Lecture 6 Rural Credit Markets 12 March Based on Chap. 7 B & U (Tutorial 4 --Lec.6) 17 March Lecture 7 Microfinace 19 March Based on Ahlin and Townsend (2007) (Tutorial 5 –Lec.7) 24 March Lecture 8 Savings, & Risk, Insurance 26 March -Mock Exam Sheet provided -Mainly based on Chap. 8 B & U & Deaton (1991) (Easter Break)

3 Lecture 9 Poverty & Vulnerability 30 April Hand in your answers -Mainly based on Ligon and Schechter (2003) and -Hoddinott and Quisumbing (2003) (Tutorial 6) 5 May A session for the Mock Exam Lecture 10 Institution and Social Capital – Role of State 12 May -Mainly based on Chap. 17 B & U.

4 1. Introduction (a) Dependency of agricultural sector in many LDCs (see Lecture 1) (1)The lag between the start of production & the realization of agricultural output- Seasonality. (2) External shocks (e.g. weather- drought/ floods), price shocks, global financial crisis. (3) Potential mechanisms for these: Savings, Insurance (Lecture 8) or Credit. World Bank,2000, World Development Report 2000/01: Attacking Poverty, Washington D.C Alderman and Paxson, 1994, Do the poor insure? A synthesis of the literature on risk and consumption in developing countries.

5 (4) Savings may not possible for the poor. Formal insurance schemes are limited. (b) The credit is often limited, particularly, for the poor. (1) Formal credit (e.g. banks or cooperatives) is limited. (2) Informal credit (credit not from formal sectors- incl. borrowing from money lenders microcredit from small NGOs, credit from relatives & friends or from employers) important. (3) A type / terms of loans vary (duration, with/ without collateral/ interest rate/ group or individual liability) to a great deal.

6 (c) Roles of government policies (1) Governmental Policies are important (whether to impose interest rate ceilings/ whether to target particular sectors/ type of business/ whether to opt for subsidized credit programmes). Risky nature of the agricultural production. (2) Efficiency vs. Equity Whether the government should liberalise the credit market?

7 (d) Information Asymmetry Information is likely to be incomplete.-Moral hazard and Adverse Selections Can monopolistic money lenders who has information on local borrowers in a village extract rents? Does the answer depend on the competition with outside lenders? i) Competitive equilibrium with complete information ii) Competitive equilibrium with incomplete information iii) Equilibrium with a fully informed monopolist (complete information) and iv) Competition between an informed money lender and uninformed outside lenders

8 1. Models (a) Assumptions- See handout.

Moral Hazard (Bardhan & Udry, p.80) i) Competitive equilibrium with complete information Assumptions: Large no. of competitive lenders. Lenders can observe the borrower’s choice of a (an index of the farmer effort) and the interest factor, i, and can write contracts that specify i and a. 9

10 If there is an equilibrium with lending, it is characterized by the solution to:

ii-1) Competitive equilibrium and moral hazard Assumptions: Large no. of competitive lenders (same as i). Lenders can not observe the borrower’s choice of a. (an index of the farmer effort). The borrower will choose the action that maximizes his utility given the credit contract offered. 11

An equilibrium is defined such that it satisfies the same conditions, plus The lender can only offer contracts such that the borrower wants to choose a2, given i2. If there is an equilibrium with lending, it is characterized by the solution to: 12

ii)-2 Competitive equilibrium and moral hazard (with collateral) Assumptions Large no. of competitive lenders Lenders can not observe the borrower’s choice of a (an index of the farmer effort). The borrower will choose the action that maximizes his utility given the credit contract offered. Borrowers and lenders are risk neutral. Each borrower owns some asset > R. If the project fails, the borrower transfers the collateral to pledged for the loan (C) to the lender. 13

Then the equilibrium, if it exists, is described by 14

Tutorial Question 2: Using the first order approach (as briefly explained by B&U), show at an equilibrium, 15

the problem of moral hazard will be completely alleviated in case with collateral (NB- if the farmer makes more effort, the risk of collateral C being taken will be reduced). Implications: -This will explain the lender’s preference for taking collateral and for the relatively rich borrowers who can afford collateral, land. - The poor households cannot have access the lending. 16

The collaterals can be transacted in the secondary market. Also, the collaterals should be free from information problems (e.g. if people realize the risk of giving their collateral (e.g. livestock) to the lender, they may not try to take care of it well). 17

This will justify the group lending without for borrowers without physical collateral (Lecture 7) –joint liability In some areas of LDCs, the labour market contract is linked with the credit contract (interlinked transaction). 18

The results depend on the assumption that both borrowers and lenders are risk neutral. If the borrowers are risk-averse, the difficulties with moral hazard will not be alleviated totally as they will not be willing to take entire the risk without some compensation from the lender. 19

iii) Equilibrium with a fully informed monopolist Assumptions:  There is only one local money lender whose wealth is larger than the total wealth of N residents in the village).  The money lender can monitor the activities of borrowers (hence a, an effort level).  The opportunity cost of wealth is the risk-free rate, rho (the opportunity cost). 20

Because of the monopoly, zero profit constraint will be relaxed. The moneylender can actually maximize The interest rate is set so that the lender maximizes his expected return and the borrower achieves the reservation utility. 21

iv) Competition between an informed money lender and uninformed outside lenders Assumptions: There is a competitive market for credit from lenders outside the village without the knowledge of borrower’s activities. As in case iii) there is a local moneylender in the village who can monitor the activities of farmers without any cost. The opportunity cost for those lenders is rho The opportunity cost for local money lender is the risk-free rate, rho (the opportunity cost). 22

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Adverse Selection 24

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i) Competitive equilibrium with complete information Assumptions: -Large no. of competitive lenders. -Lenders can observe the borrower’s type t and can offer different factors, i. 27

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29 Both type of farmers will borrow.

ii)-1 Competitive equilibrium with adverse selection Assumptions: Large no. of competitive lenders (same as before). Lenders can not observe the borrower’s type t. Lenders know the relative proportion of Type 1 and Type 2. 30

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34 The Implications As the interest goes up, Type 1 (safer) borrowers will drop out and opt for the non-farm employment without any risk. Figure 7.2 will illustrate the relationship of interest rate charged by lenders, i, and the expected income from the lending

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37 That is, there is no other levels of interest i, at which any Type t borrower would take the loan and would be better off than the utility level achieved under (and the lender still makes a profit greater than 0).

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ii)-2 Implications of Adverse selection- Credit Rationing We have so far assumed that lenders have access to an infinitely elastic supply of funds at rho. Stiglitz and Weiss (1981) - When the relationship between the expected return to lenders and the interest rate is not monotonic with an interior local maximum, there exists a supply of fund schedule which leads to a competitive equilibrium with credit rationing 40

ii)-3 Competitive equilibrium and adverse selection (with collateral) The existence of collateral can eliminate the problem of adverse selection (a pledge of collateral equals to the repayment places the entire risk of the transaction on the borrower). The results depend on the risk-neutrality of the borrower. 41

iii) Equilibrium with a fully informed monopolist 42

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iv) Equilibrium with a fully informed monopolist 44

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Conclusions We have seen by the static models Information Asymmetries may lead to the inefficient allocation of credit or to excessive loan default as a consequence of moral hazard. They may lead to monopoly profits of local money lenders with the knowledge of local borrowers. Collateral will mitigate the problems. 49