Banks, Informal Money Lenders and Asymmetric Information

A theoretical approach to explain the peculiar structure of credit markets in LDCs


Term Paper (Advanced seminar), 2005

20 Pages, Grade: A= 1,0


Excerpt

Contents

1. Introduction

2. Credit Markets in Developing Countries
2.1. Empirical Findings
2.1.1. The Size of Credit Markets
2.1.2. Informal Credit Markets
2.2. Financial Markets and Development

3. The Asymmetric Information Paradigm
3.1. The Stiglitz/Weiss Model
3.2. Application of the model to rural markets

4. Microfinance

5. Conclusion

Bibliography

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, typical 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 markets[1] 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 investments. 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

Credit markets in low income countries are typically much smaller than their counterparts in developed countries. Given the prominent position of the banking sector in most LDCs, a proxy for the size of the financial system can be found in the ratio of bank credit granted to the private sector (see de Gregorio and Guidotti 1995). Table 1 shows the large differences in the size of credit markets across countries. While on average, credit by the baking sector to the private sector accounts for 172.9 percent of their GDP, the size of credit markets in a typical low income country is only about 45 percent of GDP. In poor Sub-Saharan countries, this number is even lower still.

Table 1 The Size of Formal Credit Markets in Selected Developing Countries (2001)

illustration not visible in this excerpt

Source: World Bank 2003

Considering such limitations in credit markets, it is not surprising that in most LDCs there is evidence for a large demand overhang (Hoff and Stiglitz 1993). Apparently, at given interest rates many would be borrowers are denied access to credit. Table 2 indicates the percentage of enterprises in selected African countries who have reported that they would be willing to pay higher interest rates in order to receive a loan. While such polls would naturally have to be adjusted for the creditworthiness of the borrowers, and some measurement for financial repression by the government, the data does indicate the presence of some profound structural problems that limit the supply of credit.

Table 2 Firms with no Access to Formal Credit in Selected African Countries

illustration not visible in this excerpt

Source: African Development Bank 1998

2.1.2. Informal Credit Markets

Connected to the financing constraint is the second general characteristic of LDC credit markets, the dualism between a relatively small formal and a relatively large informal financial sector. It appears that the unmet demand for credit by the formal sector is often supplied by the informal sector. Generally, this sector comprises a quite diverse sets of institutions, ranging from interest free loans within families, rotating savings and credit associations (ROSCAs), pawnbrokers and informal commercial money lenders. The latter are of special interest for the purpose of this paper as they are usually the widest spread alternative to formal bank loans. Unfortunately, however, due to their very nature it is difficult to obtain reliable data on informal financial markets. The following is an overview over some country studies that have been commissioned by the World Bank and by the OECD.

Most studies estimate the share of credit in developing countries that comes from the informal sector to be very significant, often bigger than the formal sector as can be seen in Table 3.

Table 3 Estimates of the size of informal credit markets in rural areas of selected countries

illustration not visible in this excerpt

Sources: Robinson 2001, CIPE 2001.

The dualism between the formal and informal sector is especially accentuated in rural areas and seems to persist even in countries that have a well developed and wide spread network of formal bank branches as for example in Sri Lanka (see Wickramanayake 2003). In fact, Braverman and Guasch (1993, p. 54) state that “it has been estimated that only 5 percent of farmers in Africa and about 15 percent in Asia and Latin America have had access to formal credit; on average across developing countries 5 percent of the borrowers have received 80 percent of the [formal] credit.”

Interestingly, it appears in general that the formal and informal markets do not directly compete with each other but that they coexist as complements. Siamwalla et al. (1993, p. 161) report that in Thailand it seems that 75 percent of those active in the credit market still use the informal sector as a complement to the formal sector. Similarly, Rutherford (2000) states that many informal money lenders finance the credit they provide informally through formal loans. A lack of competition between formal and informal credit markets is also suggested by the rather different types of loan contracts the two sectors offer. This is most apparent when looking at the interest rates that the two sectors charge, which in most cases differ highly. Again, the information regarding these data is quite difficult to compare as it has usually been collected under different conditions, for different purposes and at different times in very different parts of the world. Still, one can generally see a large spread between formal and informal interest rates, with the latter often demanding interest rates that are several times higher than the former (see Robinson 2001, p. 200 for a broad overview of available studies). Moreover, the terms of the loans differ considerably concerning other factors such as maturity and collateral requirements.

However, the question to be asked here is not whether informal moneylenders contribute to the welfare of society by providing necessary services or whether informal moneylenders abuse their monopolistic position.[3] Instead, the question to be addressed here is why apparently the formal sector does not meet the demand for credit in rural areas in the first place and why – strikingly – the private sector does not appear to want to compete with the informal sector, for example by increasing interest rates and the supply of credit and letting supply equate demand. Before we turn to a possible explanation for these questions, the next section briefly discusses role of the financial sector in the economy.

2.2. Financial Markets and Development

The most basic function of a financial system becomes easily apparent when one imagines a completely underdeveloped financial system in which there are no transfers of savings from one individual to the other. In such a system, investments can only be undertaken out of personal savings. This implies an inefficiency as those who own savings might not want (be able) to invest while others with good investment opportunities might not have the available means. Consequently, in such an economy, people without an investment opportunity do not have an incentive to save and capital can not be allocated optimally. It becomes clear from this simple model that the creation of a market for credit that allows borrowers and creditors to meet would reduce this inefficiency (Kitchen 1986, p. 68).

This function can be performed much more efficiently by a set of institutions that reduce information and transaction costs and allow complex and impersonal exchanges in the sense of Douglas North. In fact, well-developed financial systems perform several critical functions to enhance the efficiency of intermediation by reducing information, transaction, and monitoring costs. Firstly, by pooling funds and acquiring information, financial markets are able to allocate capital to its highest value of use and therefore are able to raise the average return to capital. Secondly, this optimal resource allocation mobilizes additional resources by providing incentives for saving. These functions result in a more efficient allocation of resources, a more rapid accumulation of physical and human capital, and faster technological progress, which in turn feed economic growth (Creane et al. 2003).

These considerations are supported by several empirical studies that have attempted to test the relationship between financial market development and economic growth. For example, King and Levine (1993) analyzed the relationship between seven different indicators for financial system development and economic development over time, finding a strong relationship between all indicators and future growth. Carranza (2000) finds that generally capital is often allocated inefficiently in developing countries, due to structural problems connected with the limited size and inefficiency of LDC capital markets. This inefficient allocation of capital seems to have a considerably negative effect on economic growth, especially at initial stages of development. These findings are also in line with De Gregorio and Guidotti (1995) who find a strong relationship between the development of the financial sector measured as the level of credit granted to the private sector by the central bank and commercial banks and growth.[4] Apparently, again the highest effect of financial system development on growth comes from the allocative efficiency of investments.

Summing up, there appears to be ample theoretical explanation and empirical evidence for the importance of an efficient financial sector for economic development. In light of this, the limited size and the segmentation of LDC credit markets as described in section 2.1. might be significant impediments to development. Consequently, in order to overcome these obstacles to development one needs to understand their causal origins. Generally, one can distinguish between two major strands of research which have attempted to explain the reasons for the evident underdevelopment of financial markets in developing nations and particularly for the dichotomy between formal and informal credit markets. The first strand of research concentrates on the political and regulatory environment in developing countries and explains the problems of credit markets mainly as a consequence of political interferences in the market through financial repression (see Fry 1995), insufficient competition between (state owned) financial service providers, bad management and cronyism. The second school of thought concentrates more on the fundamental properties of credit markets in developing countries, chiefly among which the asymmetric distribution of information between borrowers and lenders. This latter approach will form the center piece of the remainder of this paper as it can explain the occurrence of large inefficiencies in the financial sector even in countries with a comparatively well governed banking sector[5].

[...]


[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.

[3] See Robinson (2001) and Rutherford (2000) for an overview of this interesting debate.

[4] Some authors however question that this observed correlation between economic growth and financial system development actually resembles a causality. Apparently, the causal relation between financial sector development and economic growth goes in both directions (Fry 1995, chapter 4).

[5] Of course, these two schools of thought are complements rather than substitutes and can unfold their full explanatory power only in combination with each other.

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Details

Title
Banks, Informal Money Lenders and Asymmetric Information
Subtitle
A theoretical approach to explain the peculiar structure of credit markets in LDCs
College
Johns Hopkins University  (School of Advanced International Studies (SAIS))
Course
Theories and Models of Economic Development
Grade
A= 1,0
Author
Year
2005
Pages
20
Catalog Number
V40080
ISBN (eBook)
9783638386845
ISBN (Book)
9783656180869
File size
596 KB
Language
English
Notes
Development Finance, Microfinance, Asymmetric Information, Rural Credit Markets, Stiglitz Weiss, informal money lenders, Financial System
Tags
Banks, Informal, Money, Lenders, Asymmetric, Information, LDCs, Theories, Models, Economic, Development
Quote paper
Patrick Avato (Author), 2005, Banks, Informal Money Lenders and Asymmetric Information , Munich, GRIN Verlag, https://www.grin.com/document/40080

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