Banks, Informal Money Lenders and Asymmetric
Information - A theoretical approach to explain the
peculiar structure of credit markets in LDCs

von: Patrick Avato

1. Introduction 1

2. Credit Markets in Developing Countries  1

2.1. Empirical Findings  2

2.1.1. The Size of Credit Markets  3
2.1.2. Informal Credit Markets  4

2.2. Financial Markets and Development  5

3. The Asymmetric Information Paradigm  7

3.1. The Stiglitz/Weiss Model 7
3.2. Application of the model to rural markets  10

4. Microfinance  12

5. Conclusion 14

Bibliography 16

1. Introduction

Credit markets in developing countries differ substantially from their counterparts in OECD countries. Apart from the obvious differences in institutional development, technology and productivity which are both measures for and causes of underdevelopment, typ ical LDC credit markets have two main characteristics. Firstly, their financial systems are very small compared those in industrial economies. Secondly, developing countries are characterized by very big informal financial sectors that coexist with formal credit institutions. Interestingly, credit contracts differ highly between these two sectors and there seems to be only very limited inter-sector competition. The following paper ventures to explain the persistence of these peculiarities in rural credit markets1 using the model of asymmetric information in credit markets developed by Stiglitz and Weiss. By applying the model specifically to LDC credit markets I show that asymmetric information is among the major reasons for the underdevelopment of rural credit markets. Building on these findings I then explain how Microfinance Institutions (MFI) have lately been able to overcome some of the problems of imperfect information and strive in markets formerly dominated by informal money lenders.

The first part of this paper provides an overview of the typical characteristics of credit markets in developing countries, concentrating on the limited size of LDC credit markets and on the apparent dichotomy between formal and informal finance sectors. Then, the importance of financial systems for economic development is briefly outlined in order to explain the relevance of the topic of this essay. The main part of the paper then presents the model of asymmetric information in credit markets pioneered by Stiglitz/Weiss as a possible explanation for the causal origins of these characteristics. The last part shows how successful microfinance institutions may succeed in operating in rural credit markets by their ability to overcome problems of imperfect information.

2. Credit Markets in Developing Countries

Credit markets in developing countries differ substantially from their counterparts in industrialized countries. The following chapter gives a short overview about the peculiarity of rural credit markets and assesses the theoretical implications of these peculiarities.

2.1. Empirical Findings

The structure of the financial system differs widely across developing countries, depending on historical and colonial legacies, government policies, the level of economic development and the structure of the economy. Despite these differences, however, some general observations about the characteristics of financial systems in LDCs can be made.2 The financial systems in developing countries are generally much less developed, having a much narrower range of institutions and instruments and being relatively smaller relative to the size of the economy. Most importantly, financial markets in developing countries are typically strongly dominated by the banking sector. Bond markets and stock markets are developed only rudimentarily (if at all) and the banking sector is usually dominated by a few large and often government owned banks. There typically is only limited competition between these banks and government interventions in credit markets are frequent despite of almost ubiquitous efforts of liberalizing the sector (see Mehran et al. 1998). Even in the absence of a formal banking sector, credit markets in one form or another appear to be omnipresent and exist even in the poorest and least developed regions of the world.

In fact, credit markets have a very important role in the functioning of an economy. At the most basic level, credit transactions serve to facilitate production through financing working capital and fixed capital investme nts. Typically in rural areas working capital is of the greatest importance and it is primarily used to buy agricultural inputs. Moreover, borrowing is also used for consumption purposes, for example to allow consumption before harvest or finance large expenditures such as weddings, funerals etc. Thereby, borrowing allows people to smooth consumption in face of fluctuations, especially when production is risky and insurance markets are incomplete. Two characteristics of rural credit markets, that are observable in practically every LDC, are of particular importance with respect to the topic of this paper: the relatively small amount of credit in the economy and the dichotomy between a formal and an informal credit market.

2.1.1. The Size of Credit Markets

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1 In the following, the term rural credit markets will be used synonymously for credits in developing countries.

2 In the absence of comprehensive cross country data, most of this description will be based on country specific data, which however all indicates in the same direction.