Some preliminary concepts
• Economic Transactions are either real or financial
• Real transactions: production, sale or transfer of goods and
services
• Financial transactions: creation, sale or transfer of financial
assets, including money
• Aggregate investment = savings ± capital movements from or
to the rest of the world
• Individual acts of savings and investments are NOT the
alternative sides of the same coin
• Transfer of resources from savers to investors requires some
financing channels
• Direct finance: actual saver lends to the actual spender
• Indirect finance: involves intermediaries (savers lend to
intermediaries who in turn lend to spenders)
• Intermediaries: banks and other financial institutions,
individual traders, money lenders
Some preliminary concepts
• Self finance or internal finance: spender finances his own
spending
• Each act of external financing creates a financial asset for the
lender and a financial obligation for the borrower
• Direct financing creates a single financial asset
• Indirect financing creates at least two financial assets
• Self finance does not give rise to any financial asset
• Financial stock of a country: grand total of the financial assets
owned by its population
• Negotiable financial assets (bills, bonds, debentures, shares)
and Non-negotiable financial assets (bank overdrafts, or
private loans)
• Negotiable: embodied in transferable paper form – also called
financial instruments or securities
• Markets exist for all financial assets: prices (rates of interest)
determined through the interaction of supply and demand
Some preliminary concepts
• Role of financial markets: (i) facilitates a smooth exchange of
goods and services through improvements in payments and
settlements (ii) intermediates between savers and investors (iii)
acts as a bridge between present and future
• Financial markets are different from goods markets: money is
exchanged today for a promise of return in the future whereas
goods are traded contemporaneously
• Stock market is neither saver, spender, borrower, nor lender
and, of itself, does not create financial assets – not an
intermediary but an agency, which provides the means of
contact between those who buy and those who sell securities
• Financial structure consist of the stock of various financial
assets, together with the pattern of financial institutions in
existence (institutions, instruments and activities)
• Financial development: expansion and elaboration overtime of
the financial structure
Structure of Indian Financial System
Other Financial
Banking
Private
Commercial
Co-operative
MFs
Insurance
Dev.Banks
Public
RRBs
UTI and others
LIC and others
IDBI, ICICI, SIDBI and others
Functional Classification of Financial Markets
Financial Markets
Money Markets
Call Money
CD
Credit markets
CP
Loans (Banks and others)
Capital Markets
Govt. Secu
Stock Mar
Shares Debentures
Functional Classification of Financial Markets
• Money Markets: markets for short-term financial assets that
are close substitutes for money usually with maturities of less
than a year
• Safe income-yielding outlet for short term investment of funds
both by banks and firms
• Source of short term funds to banks in need of quick liquidity
• Allows banks to economize on their holdings of excess funds
and to deploy these funds more profitably elsewhere
• Allows firms direct access to short-term funds and thus avoid
bank intermediation costs
• Source of working capital to industry (capital market is
concerned with the financing of fixed investments)
• Call money market: overnight money and money at short
notice for periods of up to 14 days - serves to balance the short
term liquidity needs of banks
Functional Classification of Financial Markets
• Commercial paper: unsecured (not backed by collateral)
promissory notes – flexible maturity period
• Highly rated corporate borrowers can obtain funds at a cost
lower than the cost of usual bank borrowing
• The issuer promises the buyer a fixed amount at a future date
but pledges no assets
• Certificate of Deposit: issued by a bank to depositors of funds
that remain on deposit at the bank for a specified period of
time - purchased and sold in the money markets
• Marketable receipt of funds deposited in a bank for a fixed
period at a specified rate of interest
Credit and Growth
• Economic activities are spread out over time
• The adoption of a new technology or a new crop
requires investment today, with the payoffs coming in
later
• Even ongoing productive activity requires inputs in
advance with revenues realized at a later point in time
• Income streams (particularly of casual labor and selfemployed) may fluctuate, which need to be
smoothened through some form of credit
Credit markets may not function smoothly
• Very difficult to monitor exactly what is being done with a loan
• Using loans for unproductive purposes → default
• Using loans for risky productive activity that may fail to pay off
→ problem of “inability to repay” or involuntary default
• Voluntary or strategic default: a borrower can repay the loan, in
principle, but simply does not find it in his interest to do so
• Voluntary default is pertinent in contexts where the legal system of
loan enforcement is weak
• Examples 1: international debt → an effective international court
of law does not exist → limited punitive measures → :
• (i) threat to advance no further loans (often lacks credibility)
• (ii) threat to cease trading relationships (subject to objections from
other economic actors in the lending country that gains from such
trade)
• Example 2: developing countries where internal courts of law are
weak or absent
Demand for credit
• Fixed Capital: capital for new startups or a substantial
expansion of existing production lines → important
determinant of the overall growth of the economy
• Working Capital: credit required for ongoing production
activity, which occurs because of a substantial lag between the
outlays required for normal production and sales receipts
• Consumption Credit
• Working capital and consumption credit are particularly
significant in the agriculture sector
• Requirement of working capital at the beginning of the crop
cycle to purchase seed, fertilizers, pesticides and so on
• Harvest failure and consumption credit
Rural credit markets
• Formal or Institutional lenders: Govt. banks, Commercial
banks, Co-operative banks and Special banks
• Formal lenders do not have much personal knowledge
regarding the characteristics and activities of their clientele.
• Problem of monitoring: how the loans are used and for what
purpose
• Divergence in the interests of lenders and borrowers →
Example: Let r = 10%; alternative projects each requiring a
startup cost of Rs. 100,000; two projects with rates of return at
15 and 20%; the projects will return gross revenues of
Rs.115,000 and Rs.120,000, respectively (no uncertainty)
Perfect coincidence of interests between the bank and the
borrower; project with 20% return will be selected; both happy
Rural credit markets
• Suppose that the return to the first project is uncertain; second
project just the same; first project pays off Rs.230,000 with
probability ½ and nothing with probability ½
• The expected revenue from the project is (½)230,000 + (½) (0)
= 115,000, just the same as it was
• The bank would like to fund the 20% project, indeed more
than it did before
• Borrower’s expected return: 120,000 – 110,000 = 10,000 for
the safe project and (½)[230,000 – 110,000] + (½)0 = 60,000
for the risky project; expected return is much higher under a
riskier project
• Conflict of interest
• What went wrong? The borrower has limited liability ; the
borrower pays up if all goes well, but if the project fails she
does not repay anything; banks seek collateral
• Banks discriminate against poor borrowers; unacceptable
collateral to the formal lenders
Rural credit markets
• Informal lenders, Information and Collateral:
• Informal money lenders (landlord, shopkeeper, and trader)
have advantage in the rural areas, in terms of collateral and
information
• A large land owner who has land adjacent to that of poor
farmer may be interested in the tiny plot as collateral; An
employer of rural labor will accept labor as collateral
• Informal money lenders often have much better information
regarding the activities and characteristics of their clientele
Some characteristics of rural credit markets
• Informational constraints: lack of information regarding the
use to which a loan will be put; lack of information regarding
the repayment decision
• Segmentation: credit relationships are personalized and takes
time to build up; fixed clientele; repeat lending
• Interlinkage: interlinked credit transactions; landlords tend to
give credit mostly to their tenants or farm workers; traders
favor lending to clients from who they also purchase grain;
segmentation on occupational lines; complementarity of some
production relationship (tenant and landlord or farmer and
trader) facilitates the credit relationship
• Interest rate variation: Very high to low or zero interest rates;
absence of interest rate can be deceptive given the interlinked
nature of many transactions; arbitrage opportunities do not
arise given the personalized relationship between the lender
and the borrower
Theories of informal credit markets
• Why the rates of interest are generally very high in the
informal credit markets as compared to the formal-sector?
• Arbitrage does not happen; interest rate differential continue to
persist; why?
• Lender’s risk hypothesis: substantial risk of default in rural
credit markets; (i) involuntary default , (ii) voluntary or
strategic default (the borrower may simply take the money and
run, or stubbornly refuse to pay up); legal enforcement
• There is an exogenous probability of repayment on every
rupee lent out ( p); probability of default is (1- p)
• Competitive rural credit market: competition between money
lenders drives the rural interest rate down to a point where
each lender on the average earns zero expected profit (over
and above the opportunity cost)
Theories of informal credit markets
• Typical money lender; L = total amounts of funds he lends out; r
= opportunity cost of funds for every money lender; i = interest
rate charged in the competitive equilibrium in the informal
sector
• Expected profit → p(1+ i)L – (1+ r)L = 0
1 r
i 
1
p
• When p = 1 (no default risk) → i = r (informal interest rates are
the same as formal-sector rates
• When p < 1 (default risk) → i > r (informal rate is higher to
cover the risk of default)
• Let r = 10% per annum; p = ½ ; then i turns out to be a steep
120% per annum
Theories of informal credit markets
• Even under competition, informal sector rates are very
sensitive to the default risk
• Risk of default is likely to be lower when we have a well
developed legal machinery and when the loans are
collateralized
• Evidence: actual rates of default in rural credit markets are
very low; formal-sector default rates measure up to about a
quarter of all loans given, in the informal sector, these rates are
significantly lower (about 5%)
• Although potential default may be important, lenders manage
to devise contracts and creates incentives to circumvent the
problem; how?
How lenders lower the default risk in the informal
markets?
• Default and fixed capital loans: larger amount to be repaid lead
to greater risk of default
• If the loan can be used by the borrower to permanently put
himself in a situation in which he never has to borrow again,
then such loans are very unlikely (e.g., rural laborer wishes to
borrow money so that he can migrate to the city and set up a
small business there)
• In the absence of legal enforcement mechanism, often the only
instrument that a moneylender has is the threat of not
advancing loans when needed in the future. But if future loans
will never be needed, then the threat has no value
• In the presence of strategic default, the overwhelming
provision of informal loans will be for working capital or
consumption purposes, rather than for fixed investments that
may permanently reduce the borrower’s future need for credit
Credit may simply be a veil for acquiring collateral!
• Default and collateral: land, output and labor as collateral,
ration card!
• Model: A small farmer is in need of a loan of size L (family
emergency)
• Landowner asks him to pledge land as a collateral for the loan;
the farmer pledges his plot of land, which is adjacent to that of
the landowner
• i = interest rate; VS = monetary value that the farmer places on
his land; VB = monetary value that the landowner attaches to
the same plot of land (VB can exceed VS)
• VS + F = monetary value of the loss to the farmer from default,
which is over and above the loss of collateral (F = loss in the
form of fear of not receiving future loans or even the threat
physical harm)
Credit may simply be a method to acquire collateral!
• We can conceive the following possibilities at the time of
repayment
• Borrower in a state of involuntary default; he looses land
• Voluntary default; loss to the borrower is VS + F; gain is that he
gets to keep the principal plus interest that he owed
• Borrower will prefer to return the loan if L(1+ i) < VS + F …..(1)
• Lender will prefer his money back if L(1+ i) > VB ………….. (2)
• Combining (1) and (2), we may conclude that loan repayment is
in the interest both parties only if VB < VS + F → lenders
valuation must not exceed the borrowers valuation by too much
• When F = 0 → lenders valuation of the collateral must be less
than that of the borrower
Credit may simply be a method to acquire collateral!
• VB > VS + F → whenever the borrower prefers to to repay the
loan, the lender actually wants him not to do so!
• How is default encouraged ? (a) raise the interest rate so that
(1) fails → if the borrower does not default involuntarily, the
circumstances will induce him to do so willfully → interest
rate on such transactions are high indeed, but the main
objective of the transaction is not to earn interest
• Why land inequalities rise in poor societies? Land is passed
from poor to rich in lieu of unpaid debt; debt contract may be
written so as to deliberately induce these transfers
• Labor collateral and bonded labor; loan may be advanced for
the express purpose of ensuring a supply of cheap labor from
the borrower
Credit may simply be a method to acquire collateral!
• Strategy works better for consumption loans than production
loans
• Consumption loan (illness in the family) → amount is fixed
and can not vary with the rate of interest
• Production loan → high interest rate may be self-defeating
because the borrower can scale back the amount of loan by
reducing the extent of his productive activity
• Explanation of why interest rate may be high for some types of
credit transactions but not for others
Default and Credit Rationing
• Credit rationing: at the going rate of interest in the credit
transaction, the borrower would like to borrow more money,
but is not permitted to by the lender
• The loan-interest combinations that lie to the “left” of the
demand curve
Model
• The moneylender wishes to allocate his available funds in a
way that maximizes his rate of return on the funds
• Large number of potential farmers who could borrow
• Loan is used as working capital to buy inputs for production
• Production function represents output at various levels of
working capital (L)
• Total cost to the farmer of borrowing an amount L: → L(1 +
i), where i is the rate of interest
Default and Credit Rationing
• The money lender does not have unlimited monopoly power
and the farmer can always borrow from other sources after a
point
• The farmer can always have access to a net profit of A by
borrowing elsewhere
• The money lender can not choose i so high that he pushes the
farmer to a profit of less than A
• The vertical difference between the production function and
the cost line (output minus loan costs) is the farmer’s profit;
this must be kept at least as large as A
• Set the marginal product equal to marginal cost, 1+ i (tangent
to the production function is parallel to the cost line)
• Choose the largest interest rate i so that the farmer’s surplus
does not fall short of A → at i*, the surplus is just A
• The farmer receive his desired loan size (L*) given that the
interest rate that he must pay is i* - does not involve credit
rationing
Default and Credit Rationing
• Participation constraint: f(L) – L(1 + i) ≥ A : Constraint on
the money lenders choice of interest rate
• Possibility of strategic default: the money lender will not lend
to the farmer in the future
• The borrower’s mental time horizon ; the importance that the
borrower attaches to future gains and losses; the extent to
which the future concerns the borrower when he makes current
decisions
• Assume that at each date, the farmer considers about the gains
and losses of his current decisions in the coming N periods
• What does the farmer get over his entire mental horizon of N
dates: the amount per date multiplied by N
N [f(L) – L(1 + i)]
Default and Credit Rationing
• What does the farmer get if he decides to default?
• Today, he will get all of f(L); tomorrow onward, he is excluded
by our money lender; farmer goes to alternative lenders; gets A
per period
• Total gain over the N period mental horizon is f(L) + (N-1)A
• For default not to occur → N [f(L) – L(1 + i)] ≥ f(L) + (N-1)A
N
f (L) 
L(1  i )  A
N 1
Default and Credit Rationing
• No-default constraint: looks like the participation constraint
except for the term N / (N-1) that multiplies the cost line
• N / (N-1) always exceeds 1
• The shorter the mental horizon, the more difficult it is to meet
the no-default constraint
• If N = 1 (the farmer never contemplates the future
consequences), the constraint can never be satisfied → the
farmer will always default on the loan, so no loans will be
advanced
• If the farmer is very farsighted; N is very large; N / (N-1) has a
value close to 1 → only the participation constraint matters
• Situations in which N is neither too large, nor too small
Default and Credit Rationing
• Graphical analysis is the same: Modify the cost line by
multiplying it by the factor N / (N-1)
• Set the marginal product equal to marginal cost, N / (N-1)(1+ i)
(tangent to the production function is parallel to the modified cost
line)
• The interest rate i** and the associated loan size L** represent the
moneylender’s optimal solution when default is possible
• MP of the loan equals N / (N-1)(1+ I**), which is not the true MC
of the loan as faced by the borrower, 1 + i**
• The borrower would like to borrow more at the going interest rate
i**
• The borrower would like to borrow L* in a competitive market
where all contract can be costlessly enforced
• The moneylender’s preferred contract involves credit rationing
Informational Asymmetries and Credit Rationing
• Lending risk may vary significantly from borrower to borrower
• Risk may be correlated to the characteristics of the borrower that
are observable to the lender → the lender can select his clients or
charge appropriately higher rates for the high-risk clients
• Risk also depends on other qualities that are not observable (skill,
thriftiness, ability to face crisis etc)
• When the qualities not observable, how will the lender choose his
customer, and decide the interest rate?
Model
• The moneylender faces two types of potential customers: safe type
and risky type
• Each type need a loan of (the same) size L to invest in some
project or activity; the lender has enough funds to lend just one
applicant
• The borrower can repay only if the project produce sufficient
returns to cover the repayment
Informational Asymmetries and Credit Rationing
• Assume that the safe type is always able to obtain a secure return
of R (R >L)
• The risky type obtain R * (R * > R), but only with probability p;
there is a probability 1- p that he gets a return of 0
• What is the highest interest rate i for which the safe borrower
wants the loan?
• Because his net return is given by R – (1 + i)L, the highest
acceptable rate for him is i1 = R / L-1
• For the second borrower, the expected return is p[R* - (1+ i)L];
hence the maximum rate he is willing to pay is i2= R* / L-1
• Because R* > R, we have i2 > i1
• The risky borrower is willing to pay a higher rate of interest than
the safe borrower, and this interest rate is independent of his
probability of success, p (limited liability)
Informational Asymmetries and Credit Rationing
• If the lender charges i1, both will apply for the loan
• If a rate slightly higher than i1 is charged, the safe borrower
drops out; the lender may then go all the way up to i2
• Which interest rate to charge?
• If i2, the expected profit of the lender is Π2 = p(1+ i2)L - L
• if i1, he attracts each type of customer with probability ½. →
Expected profit Π1 = ½ i1L + ½ [p(1+ i1)L – L]
• The lender will be reluctant to charge the higher interest rate
when Π1 > Π2 → stick to i1 and take the 50-50 chance of
getting a safe customer
• Credit rationing in equilibrium → one will get the loan, the
other will not
• Price is not raised even in the face of excess demand: raising
the price would drive away the good borrower instead of the
bad one, and the higher possible return cannot compensate for
the lowered chance of repayment
Informational Asymmetries and Credit Rationing
• The expected return to the bank depends on the probability of
repayment - the bank would like to identify borrowers who
are more likely to pay - screening devices to identify ‘good’
borrowers
• Interest rate itself is one of the screening device: those who are
willing to pay high interest rates may, on average, be investing
in riskier projects
• People are willing to borrow at high interest rates because they
perceive their probability of repaying the loan to be low
• As interest rate rises, the average “riskiness” of those who
borrow increases, possibly lowering the bank’s profits
• As interest rate rises, it induces the borrowing firms to
undertake projects with lower probabilities of success but
higher pay-offs when successful
Credit Policies for rural areas
• Needs of rural credit can not be adequately served with the use
of large financial institutions such as commercial banks
• Two kinds of policies (i) expand formal credit to agents who
are likely to use these funds in informal markets (ii) design
credit organizations at the microlevel that will take advantage
of local information in innovative ways
• Vertical formal-informal links: large land owners and traders
have better collateral; from the point of view of banks, they are
good credit risks
• Informal lenders use the funds to cash in on their informational
advantage in informal markets
• Loans to co-operative groups
• “Vertical” links between informal and formal credit systems
(not the policy of “horizontally” displacing one system by
another)
Credit Policies for rural areas
• Do the schemes that promote formal-informal linkages
intensify competition among informal lenders?
• Direct effect → intensified competition per se tends to depress
the interest rate
• Indirect effects
• Costs of monitoring: the costs of administering a loan,
clearing credit histories, and tracking the loan to make sure
that it is repaid
• Expansions of formal credit → number of active money
lenders increases → more alternative to the borrowers →
raises the probability of default → costs of monitoring
increases → raise the equilibrium rate of interest
• Intensified competition can be counterproductive from the
point of view of the borrowers
Credit Policies for rural areas
• Collusion: lenders may explicitly or implicitly agree to not
invade each other’s territory
• Differential Information: lenders may have differential
information regarding borrowers
• Lender A can figure out who the good borrowers are, but
lender B can not
• A can siphon off all the good borrowers if he does not face
credit ceiling
• If A faces credit ceiling, he can not siphon off all the good
borrowers; lender B faces a mix of borrowers; the mix might
still be profitable for B to operate
• Expansion of formal sector credit will allow A to siphon off
even more good borrowers; B may find it no longer profitable
Credit Policies for rural areas
• Numerical illustration
• 100 borrowers; each borrower seeks to borrow Rs 1,000; two
lenders (A and B)
• Opportunity cost of funds for each lender is 10%; each lender
charges 50% on informal loans
• Each lender has a credit limit (x), which is the total number of
borrowers that each lender can lend to at the rate of Rs 1,000
each
• 80 of the 100 are “good” and 20 are “bad”; good borrowers
will return Rs 1,500; bad borrowers default
• Lender A can figure out who the good borrowers are, but
lender B can not
• If x < 80, lender A will use all his resources to lend to good
borrowers
• Lender B faces a population of 100 - x , among whom 80-x are
good
Credit Policies for rural areas
• Expected value of a loan is (80 – x) / (100 – x) 1,500 →
probability of repayment times the full amount, plus the
probability of default times zero
• B will be willing to lend as long as
80  x
1,500  1,100
100  x
• 1,100 is the opportunity cost of the lender
• The inequality is satisfied as long as x is no greater than 25;
otherwise it will fail
• If x is expanded by means of a formal sector policy to increase
credit lines, both A and B will expand their lending activities,
but as x crosses 25, lender B will shut down altogether
Credit Policies for rural areas
• Micro finance
• The Grameen Bank of Bangladesh: groups of borrowers rather
than individuals (typically 5 members); average loan size of
$100; no collateral; 12% real rate of interest; 90 % of the
borrowers women; average repayment rates of over 97%
• In the event of a default, no group member is allowed to
borrow again; groups need to be formed carefully (innovative
use of information by the bank when it has no a priori access
to it)
• Self selection of good credit risks
• Lending of individual means that the risky types outbid the
safe types in the presence of limited liability
• Group formation drives the risky types out of the market
Credit Policies for rural areas
• Peer monitoring: individual borrowing under limited
liability leads to excessive risk taking, because the
borrower fails to internalize the costs of project
failure; groups will put pressure to cut back on the
level of riskiness
• Potential drawbacks: What will happen when one
member runs into genuine financial difficulties and
must default ?
• Other members may also default, because the group’s
credit rating is destroyed anyway
• Peer monitoring may backfire as well: there may be
excessive pressure to choose overly safe outcomes;
tendency to be overconservative in the choice of
projects
References
Chapter 14 in Debraj Ray (2004) “Development Economics”
Oxford University Press, New Delhi
Chapter 13 in Kaushik Basu (1997) “Analytical Development
Economics: The Less Developed Economy Revisited”, The
MIT Press, 1997.