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To what extent does the theory of credit rationing explain the phenomenon of
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Research · September 2015

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 UNIVERSITY OF AUCKLAND

To what extent does the theory of

credit rationing explain the
phenomenon of microfinance?

Submitted by: Pawani Malhotra

Supervised by: Prof. Anthony Endres

A dissertation presented in partial fulfilment of the requirements for the Degree

of Arts with Honours in Economics of The University of Auckland, 2014
Abstract

Microfinance is a phenomenon that has received a lot of attention from policy makers and development

practitioners. By successfully serving low-income borrowers, microfinance has proved that they are

valuable customers. Consequently, traditional banks have been urged to re-examine their approach to the

rural credit market. Motivated by this success, I aim to identify the economic theory that explains the

phenomenon of microfinance. In particular, I focus on the theory of credit rationing. To achieve this aim,

first I discuss key insights on credit rationing developed from the well-known Stiglitz-Weiss model.

Secondly, I highlight significant features that distinguish the rural credit market in developing countries

from other credit markets. Against this background, I identify imperfections that exist in the rural credit

market in developing countries. These imperfections help build a case for government intervention. For

this reason, I discuss the impact of policies that were implemented to remedy credit market imperfections.

Microfinance institutions (MFIs) have emerged worldwide as a practical means of dealing with these

problems. Hence, I analyze non-traditional mechanisms within the microfinance model that enable MFIs

to cope with rural credit market imperfections. My analysis shows that the theory of credit rationing

provides limited explanation of microfinance. This theory helps identify imperfections in the market that

microfinance operates in and therefore, it provides a rationale for non-traditional mechanisms that are

implemented by MFIs. But a number of aspects of microfinance cannot be explained using the theory of

credit rationing. These include focus on entrepreneurship and role of social capital. Hence, further

research must be conducted to identify other economic theories that provide the foundations for

microfinance. Literature on the theoretical underpinnings of microfinance is thin. Through this essay, I

have attempted to bridge the gap between economic theory and this phenomenon.

2
Acknowledgements

I would like to thank everyone who has contributed to the completion of this dissertation. In particular, I

would like to thank my supervisor, Prof. Anthony Endres for the guidance, encouragement and for

reviewing countless versions of the dissertation. I am also grateful to Mr. Geoff Cooper, the Chief

Economist at the Auckland City Council for sharing his research on Microfinance programs in Myanmar.

Finally, I would like to thank my family and friends for a number of hours of proof reading and

reviewing.

3
Table of Contents
Acknowledgements ....................................................................................................................................... 3
1 Introduction ............................................................................................................................................... 5
2 Development of credit rationing literature................................................................................................. 6
2.1 Stiglitz-Weiss (1981) .................................................................................................................... 9
2.1.1 Objections raised against the Stiglitz-Weiss framework..................................................... 13
2.2 Developments in credit rationing literature since Stiglitz-Weiss (1981) .................................... 14
3 Rural Credit Markets in developing countries ......................................................................................... 16
3.1 Significant Features of Rural Credit Markets ............................................................................. 16
3.1.1 Scarce Collateral ................................................................................................................. 16
3.1.2 Underdeveloped Complementary Institutions..................................................................... 16
3.2 Market imperfections identified using the formal literature on credit rationing ......................... 17
3.2.1 Enforcement Problems ........................................................................................................ 17
3.2.2 Imperfections in Information .............................................................................................. 19
3.2.3 Adverse Selection ............................................................................................................... 19
3.2.4 Moral Hazard ...................................................................................................................... 22
3.2.5 High transaction costs ......................................................................................................... 25
4 Government Intervention to increase welfare .......................................................................................... 25
4.1 Policies introduced to increase lending ....................................................................................... 25
4.1.1 Lack of collateral ................................................................................................................ 26
4.1.2 High transaction costs and inherent risks ............................................................................ 26
4.2 Criticism of government intervention ......................................................................................... 27
5 Microfinance ............................................................................................................................................ 29
5.1 Group Lending ............................................................................................................................ 30
5.2 Substitutes for collateral.............................................................................................................. 32
5.3 Dynamic Incentives .................................................................................................................... 32
5.4 Regular repayment schedules...................................................................................................... 33
6 Conclusion ............................................................................................................................................... 33
References ................................................................................................................................................... 35

4
1 Introduction

In the 1970s, Mohammad Yunus, a Professor at the University of Chittagong, started making small or

'micro' loans to local villagers. Today, the microfinance model developed by him is being replicated by a

number of institutions worldwide that are serving more than 204 million clients (The Microfinance

Gateway, 2013). The unexpected success of this small idea has proven that low-income borrowers are

valuable customers. There are a number of puzzles that surround this concept. For this reason,

microfinance has attracted attention of policy makers and development practitioners worldwide. This

essay attempts to explain the phenomenon of microfinance using economic theory as literature on this

topic is thin and inadequate. In particular, through this essay, the author aims to answer the question: To

what extent does the theory on credit rationing explain the phenomenon of microfinance?

Information is largely ignored but it has the potential to change certain aspects of organizations. It is

imperfect as it is costly to obtain and is dispersed over a large number of individuals. As a result, there are

important asymmetries of information. The extent of information asymmetries is affected by actions of

firms and individuals (Stiglitz, 2000). The Economics of Information focuses on the impact of these

imperfections on the behaviour of market participants and the equilibrium, if any, that emerges in such

markets. Economists like Hayek, Stigler and Stiglitz, have proposed solutions to problems associated with

information 1. This essay focuses on perhaps the most interesting and significant results in markets with

imperfect information presented by Stiglitz, the concept of credit rationing. In the loan market at an

interest rate r̂ * , the market may not clear. In spite of an increasing demand for funds from the borrower,

the supply of credit by the lender remains fixed or is rationed owing to information problems. This

phenomenon is called credit rationing.

1
Hayek posits that knowledge is dispersed over a number of individuals and the price mechanism acts to coordinate
separate actions of people.
Stigler analyzed the impact of search for information on ascertaining market price. He concludes that consumers
conduct search only when the marginal benefits from search exceed the marginal costs attached to the process.
Stiglitz's contribution to Economics of Information stems from his identification of selection and moral hazard
problems that are equally important.

5
 To fulfill its aim, this essay will explore the landmark model developed by Joseph E. Stiglitz and Andrew

Weiss in 1981 in their paper 'Credit Rationing in Markets with Imperfect Information' in section two. In

order to put this model in context, this essay will trace the contours of formal literature on credit-rationing

that was developed before and after the Stiglitz-Weiss model. I realize the limitations of merely tracing

the outline of literature, but I take this approach due to space constraints. There are significant differences

between the rural credit market in developing market and other credit markets. In section three, this essay

identifies these differences and applies the literature on credit rationing, to identify imperfections in the

rural credit market in developing countries. These imperfections include enforcement problems,

information problems such as adverse selection and moral hazard and high transaction costs. These

imperfections that plague the rural credit market in developing countries build the case for government

intervention to increase lending and welfare. To analyse the impact of such intervention, section four of

this essay discusses the purpose and impact of the policies that were introduced by governments in

developing countries. Microfinance schemes have developed in the breach of all these problems. Various

aspects of microfinance such as group lending with joint liability, peer monitoring, regular repayment and

dynamic incentives have helped this concept to survive in spite of the challenges of operating in rural

credit markets. This essay will therefore focus on how these aspects of microfinance help lenders cope

with imperfections. While the theory of credit rationing throws light on certain features of microfinance,

further work must be carried out to explain the phenomenon of microfinance fully.

2 Development of credit rationing literature

Early interest in credit rationing was driven in part by questions about the role that it might play in

transmitting macroeconomic effects of monetary policy as it was related to research on the 'availability

doctrine' (Calomiris et al, 2008). According to the 'availability doctrine', restrictive monetary policy leads

to a decline in the quantity of credit that is supplied to borrowers by lenders irrespective of the elasticity

6
of demand for borrowed funds (Scott, 1957) 2. Through a number of studies 3, it has been shown that credit

rationing has important implications on the effectiveness and timeliness of monetary policy.

Subsequently, attempts were made to link credit rationing with Development Economics. This resulted in

two key findings. Firstly, in his book 'Money and Capital in Economic Development', McKinnon shows

that government policies in developing countries such as high reserve requirements; high inflation and

interest-rate ceilings on deposits can lead to rationed deposits (Calomiris et al, 2008). Through lending

mandates and interest-rate ceilings, funds available for lending are rationed by restrictions on who could

bid for these funds (Calomiris et al, 2008). Secondly, George Akerlof , in his article, 'The Market for

'Lemons: Quality Uncertainty and the market mechanism' written in 1970 draws the attention to the

possible effects of information on the speed of development of the economy of a developing country. In

the absence of policies that restrict beneficial lending, all borrowers with projects that yield positive NPV

would be able to obtain funding (through either debt or equity). But Akerlof shows that if markets are

unable to distinguish between good and bad risks, lending might not be feasible (Calomiris et al, 2008).

According to Akerlof, the failure to develop institutions capable of producing credible information about

borrowers, could play an important role in financial underdevelopment. Many development economists

have come to recognize that the failure to properly allocate funds in the loan market is an important

potential impediment to growth in developing countries. This occurs due to the absence of institutions

that allow for the effective screening of potential borrowers (to mitigate adverse selection) or ongoing

monitoring of borrowers' actions (to mitigate moral hazard) in such countries. This is a broad

phenomenon of which credit rationing is a special and extreme case (Calomiris et al, 2008).

Jaffee and Modigliani (1969) shifted focus to the banking industry as they attempted to answer the

question on whether it is rational for commercial banks to ration credit by means other than price. They

2
Scott (1957) shows that monetary policy operates through a 'credit channel' in which contractionary policy affects
the economy through a decrease in supply of funds available. Blinder and Stiglitz (1983) show that the transmission
of monetary policy affects the economy as it impacts changes in terms of lending including not only changes in
interest rate at which loans are available but also the size of the loan that can be raised.
3
See Hodgeman(1960); Freimer and Gordon (1965); Kane and Malkiel (1965)

7
posit that interest rate cannot clear excess demand in the loan market, irrespective of whether this excess

demand reflects a single borrower or a group of borrowers. Hence, rationing would exist if every potential

borrower received a loan but one that was smaller than that desired at the equilibrium interest rate (Jaffee

and Modigliani, 1969). In their model, Jaffee and Modigliani (1969) focus on the three determinants of

the problem- supply of loans, demand of loans and the interest rate at which these loans are available.

They show that credit rationing is the direct result of the exogenous assumption that borrowers within a

given class or group must be charged the same interest rate by the lender, in spite of observable

differences among them (Jaffee and Modigliani, 1969). By modelling both supply and demand sides of

the market, the equilibrium interest rate in this model was endogenized.

Early work on credit rationing firmly established the idea that at equilibrium, the credit market is

characterized by a rationing equilibrium. But solutions that were identified in these models relied on

restrictive assumptions about agent preferences or the contracts that could be deployed (Calomiris et al,

2008). Modern credit rationing theory, on the other hand, is based on the developments in the Economics

of information that took place in 1970s and 1980s. In particular, two key problems associated with

information asymmetry were identified and developed - the selection problem 4 and the incentive

problem 5. Selection problems concentrate on characteristics of the items being transacted- on productivity

of workers (their strengths and weaknesses), investors want to learn about which assets they might want

to invest in, insurance companies want to learn about the probability that their customers would have an

accident or get sick (Stiglitz, 2000). Moral hazard problems focus on behaviour- how hard would the

employees’ work, care that must be taken to avoid an accident. As financial markets are characterized by

information asymmetry, in 1981, Joseph Stiglitz and Andrew Weiss published a model in which credit

rationing arises as a result of these problems.

4
The earliest contribution to the literature on 'selection' can be traced back to Mirrlees (1971) who attempts to design
a taxation system to maximize social welfare.
5
Arrow(1971) identified a second category of information problems - moral hazard. He put this in the context of
insurance: when someone is insured against a risk, they lack incentives to take actions to avoid risk.

8
Stiglitz and Weiss (1981) focus on situations where some borrowers are completely rationed out of the

market, even though they would be willing to pay an interest rate higher than that prevailing in the

market. This was the first model that 'fully endogenized contract choice' (Calomiris et al, 2008) with a

'stable, rationing equilibrium' (Calomiris et al, 2008). Owing to the importance of this work in formal

credit rationing literature, this essay focuses on this landmark model.

2.1 Stiglitz-Weiss (1981)

The objective of the paper by Stiglitz and Weiss (1981) was to show that in equilibrium a loan market

may be characterized by credit rationing. The interest rate charged by a bank itself affects the riskiness of

the pool of loans by either sorting potential borrowers (adverse selection) or affecting the actions of the

borrowers (moral hazard). Both these problems

arise from asymmetric information.

Borrowers have different probabilities of

repayment but banks cannot identify or

separate the "good" borrowers from the "bad"

(Stiglitz and Weiss, 1981). Since, the expected

return of the lenders depends on the probability

Figure 1: Expected interest rate to the bank,

with which borrowers repay their loan, it is

(Stiglitz-Weiss, 1981)

in the interest of the bank to identify those borrowers who are more likely to repay. Thus, the bank needs

screening devices to identify the 'good borrowers'.

Prices or interest rates in this case act as a screening device to distinguish good risks from bad risks. Let

θ index projects and R be gross returns. For each project θ there is a probability distribution F(R, θ )
that cannot be altered by the borrower (Stiglitz and Weiss, 1981). Different firms have different

probabilities of returns. Let us assume that the bank is able to distinguish between projects with different

9
mean returns. Stiglitz - Weiss, (1981) focus on decision problem of a bank having the same mean return

that is Ε(θ1 ) = Ε(θ 2 ) . If two projects have the same expected return but θ1 > θ 2 , then θ1 is considered a

riskier project. If the borrowed amount is B, collateral is C, return is R and the interest rate is r̂ . The

individual defaults if R + C ≤ B (1 + rˆ) The net return to the borrower is π ( R, rˆ) where

π ( R, rˆ) = max( R − (1 + rˆ) B;−C ) . The return to the borrower can be written as

ρ ( R, rˆ) = min( R + C ; B(1 + rˆ)) . Stiglitz and Weiss (1981) pinpoint the four theorems that prove that as

the interest rate increases, the expected return of the bank decreases as the riskiness of the bank's loan

portfolio increases. These are as follows:

Theorem 1: Let θ denote the value of θ

ˆ
such that expected returns are zero, that is

∫ max[R − (1 + rˆ) B;−C ]dF ( R,θˆ) = 0 then if θ > θˆ , the firm borrows.
0

dθˆ
Theorem 2: drˆ > 0 , that is, as r̂ increases, the pool of applicants becomes riskier which is shown by

differentiating the previous expression.

dρ
Theorem 3: dθ < 0 which implies that bank returns are a decreasing function on the riskiness of the

loan.

Theorems 2 and 3 prove that the expected returns of the bank are non-monotonic in the interest rate.

Theorem 4: Expected returns are non-monotonic as seen in figure 2.

10
Once non monotonicity of the lender's return in the interest rate is established, the possibility of credit

rationing follows immediately. Profit-maximizing lenders will not voluntary choose to raise the interest-

rate beyond where the adverse

selection effect dominates

(Stiglitz and Weiss, 1981). If

excess demand exists in the

market at this rate, credit

rationing will be the equilibrium.

Paradoxically, in this model the

very best credit risks do not seek

funding because they do not find

Figure 2: Expected return to the bank with rising
interest rate (Jorda, 2014)
it worthwhile (Jorda, 2012).

They voluntarily drop out of the

market because the cost of being pooled with higher-risk borrowers is too large. The rationed borrowers

are the higher-risk borrowers who stay in the market and request funding.

Stiglitz and Weiss (1981) also show how changes in the interest-rate may affect the borrower's choice of

project. The moral hazard in project choice (referred to as "asset substitution") can be another reason that

the lender's expected return is non-monotonic in the interest-rate. Interest rate charged by lenders affects

the actions or the behaviour of the borrowers. Higher interest rates induce firms to undertake projects with

lower probabilities of success but higher payoffs when successful (Stiglitz and Weiss, 1981). Jorda (2012)

shows this result algebraically. If at a given interest rate r, a risk neutral-firm is indifferent between two

projects, an increase in the interest rate results in the firm preferring the project with the high probability

of bankruptcy (but higher return). Let's assume that there are two projects X and Y and project X's (Y's)

return in the good state is RX(RY); 0 in the bad state, with RY> RX . Let pX (pY) denote the probability of

11
project X (Y) succeeding, then pX> pY which implies that project X is more likely to succeed. Let us also

assume that pXRX> pYRY then the expected returns are:

E (π X ) = p X ( R X − (1 + r ) B) − (1 − p X )C
E (π Y ) = p Y ( R Y − (1 + r ) B) − (1 − p Y )C

where B is the amount borrowed and C is the collateral (Jorda, 2012). Then E (π X ) > E (π Y ) if and

only if:

p X R X − pY RY
> (1 + r ) B − C
p X − pY

Let r * be such that E (π X ) = E (π Y ) so that the previous expression holds with equality. Then, Jorda

(2012) shows that:

• if r < r * then E (π X ) < E (π Y ) that is the firm chooses the low risk project

• if r > r * then E (π X ) > E (π Y ) that is the firm chooses the high risk project

Returns to the lender are:

• if r < r * then p X (1 + r ) B + (1 − p X )C

• if r > r * then p Y (1 + r ) B + (1 − p Y )C

Also note that p X (1 + r ) B + (1 − p X )C > p Y (1 + r ) B + (1 − p Y )C

Hence, the lender will choose r < r * which results in credit rationing. As the terms of contract change,

the behaviour of the borrower also changes. The interests of the borrower and the lender do not coincide.

On the one hand, the borrower is only concerned with the return on the investment that is earned when the

firm does not go bankrupt (Jorda, 2012). On the other hand, the lender is concerned with the actions of the

12
firm only to the extent that they affect probability of bankruptcy, and the returns in those states of nature

in which the firm does go bankrupt. Since information is not perfect or free of cost, the bank is unable to

stipulate the actions of the firm. In the absence of direct control over all actions, the bank formulates the

terms of the contract in a manner designed to induce the borrower to take actions which are in the interest

of the bank and attract low-risk borrowers (Jorda, 2012).Therefore, there is an incentive for the lender to

ration credit rather than increase the interest rate when there is an excess demand for loanable funds.

Models of credit rationing need not posit credit rationing for all borrowers. Realistically, some borrowers

may be subject to rationing while other borrowers are not (Stiglitz and Weiss, 1981). Borrowers not

subject to rationing may be able to avoid rationing because their prospects are more observable, or

behaviour is more controllable.

This analysis by Stiglitz and Weiss can be extended to a number of principal-agent problems. For

example, in agriculture the bank (principal) corresponds to the landlord and the borrower (agent) to the

tenant while the loan contract corresponds to a rental agreement (Calomiris et al, 2008). Under such a

contract, tenants equate the disutility that arises from effort with their share of their marginal product

rather than their total marginal product. Therefore, too little effort will be forthcoming from agents.

2.1.1 Objections raised against the Stiglitz-Weiss framework

An objection to the analysis conducted by Stiglitz and Weiss is based on the argument of collateral. When

there is excess demand, then why do banks not charge higher interest rates or increase the collateral

requirements? An increase in the liability of the borrower in the event that the project fails reduces the

demand for funds and the risk of default while increasing the return to the bank. This would imply

decreasing the debt to equity ratios (Stiglitz and Weiss, 1981).

Stiglitz and Weiss (1981) cite a clear case in which reductions in debt to equity ratios are not optimal.

Smaller projects have a higher probability of failure and all projects have the same amount of equity.

Hence, smaller projects will have smaller debt to equity ratios and will seem more favourable even

13
though the probability of failure is higher. In such circumstances, increasing collateral requirements of

loans will imply financing smaller projects. If projects either succeed or fail, and yield a zero return when

they fail, then the increase in the collateral requirement of loans will increase the riskiness of loans

(Stiglitz and Weiss, 1981). Another case is when there are projects with different equity, but require the

same investment (Stiglitz and Weiss, 1981). In this case, debt remains constant while the equity changes.

Wealthy borrowers who might have succeeded in risky endeavours in the past would have a higher equity

than other borrowers. These borrowers are likely to be less risk averse than the more conservative

individuals who have in the past invested in relatively safe securities, and are as a result less able to

furnish large amounts of collateral. In both these cases, collateral requirements will lead to adverse

selection effects. Stiglitz and Weiss (1981) show that wealthier individuals are likely to be less risk

averse. This implies that those who opt for most capital would also be the ones willing to take the greatest

risk. If this effect is sufficiently strong, it will lower the bank's return.

2.2 Developments in credit rationing literature since Stiglitz-Weiss

(1981)

Studies that were conducted after the Stiglitz-Weiss model (1981) on credit rationing have focused on

either gathering empirical evidence to prove that credit rationing is significant 6, or have applied the key

insights developed by Stiglitz and Weiss to other contexts 7. Attempts have also been made by economists

to extend the model developed by Stiglitz and Weiss. A noteworthy contribution was made by Stephen D.

Williamson developed in his paper titled "Costly Monitoring, Loan Contracts, and Equilibrium Credit

Rationing" written in 1987. The purpose of the paper was to show that in a credit market with

6
Some examples include Berger and Udell (1992) who presented evidence on the empirical significance of credit
rationing; Munnell et al (1996) collected data to test the hypothesis that there is a negative relationship between
minority and low income access to mortgage market & Ross and Yinger (2002) show the minority- white loan -
approval disparities or rationing on the basis of race.
7
Some examples include Blinder and Stiglitz (1983) on the effect of credit constraints on economic activity;
Calomiris and Kahn (1991) on the role of demandable debt in structuring optimal banking arrangements; Calomiris
et al (1994) on helping minorities and the poor get access to housing finance; Calomiris and Mason (2003) on bank
distress during depression; Cavalluzzo and Cavalluzo (1998) & Cavalluzzo and Wolken (2005) on the
discrimination against small businesses in the credit market

14
asymmetrically informed lenders and borrowers and costly monitoring, equilibrium credit rationing as

shown by Stiglitz and Weiss (1981) can exist. Williamson believes that an advantage of this approach is

that debt contracts can be derived as optimal arrangements between borrowers and lenders as they serve

to economize on monitoring costs.

To present his argument, Williamson (1987) assumes that as the loan rate increases, the probability that

monitoring occurs and the expected cost of monitoring to the lender also increase, given that the optimal

contract is a debt contract. In equilibrium, that agents who do not receive loans 'cannot bid these loans

away from those who do by charging a higher interest rate' (Williamson, 1987) as this would decrease the

expected return to the bank, as in Stiglitz-Weiss (1981). In this model, the equilibrium that emerges can

be of two types - one where rationing occurs and the other where it does not. The quantity of loans and

interest rate depend on the kind of equilibrium that emerges. If there is rationing, there are quantity

effects but if there is no rationing, such effects are absent (Williamson, 1987). These results are similar to

the 'availability doctrine' discussed before. Williamson (1987) assumes that the lender can observe the

outcome of the borrower's project at some positive cost. If the borrower reports a successful project

return, it repays the loan and no monitoring is needed. But if the borrower reports a bad outcome and

defaults, the bank incurs monitoring cost to verify the loss. Hence Williamson (1987) shows that neither

adverse selection nor moral hazard are required for rationing to exist.

Through the models developed in the formal literature on credit rationing so far, economists have

examined several information asymmetries that generate rationing in an otherwise competitive market.

Adverse selection, moral hazard and monitoring costs are asymmetries that are shown to cause credit

rationing. Studies suggest that an increase in interest rates would not have a symmetric effect on loans

relative to a decrease in rates (Jorda, 2012). An increase in interest rates may lead to credit rationing while

a decrease in rates may have no effect. Furthermore, the reduction in interest does not always increase the

availability of funds. In fact a decrease in interest rates may be accompanied by a decrease in the supply

of funds (Jorda, 2012). The rationing equilibrium that emerges precludes borrowers from the market

15
owing to information problems. When combined with significant features of the rural credit market in

developing countries, this phenomenon gives rise to a number of market imperfections that arise in rural

credit markets in developing countries.

3 Rural Credit Markets in developing countries

The following section focuses on distinguishing features of the rural credit markets from other credit

markets. In the light of these features and using the formal literature on credit rationing, imperfections in

the rural credit market in developing countries are identified.

3.1 Significant Features of Rural Credit Markets

There are two features that describe all credit market to some extent - collateral security and

underdevelopment of 'complementary institutions' (Besley, 1994). Besley (1994) believes that these

problems are felt more acutely in rural credit markets and in particular, rural credit markets in developing

countries. Therefore, the difference between rural credit markets in developing countries and other credit

markets is the degree to which these features affect the market.

3.1.1 Scarce Collateral

To solve the problem of repayment in credit markets, lenders demand physical assets in the form of

collateral. In case the borrower defaults, these assets can be seized. In rural credit markets, such assets are

hard to come by as borrowers are too poor to have assets that can be collateralized (Besley, 1994). These

markets are also characterized by poorly developed property rights. This implies that even if borrowers

were able to provide collateral in such markets, it is difficult to appropriate assets in the event of default.

3.1.2 Underdeveloped Complementary Institutions

Besley (1994) points out that credit markets in rural areas of developing countries lack a number of

features that are taken for granted in industrial countries. The absence of a literate and numerate

population, poorly developed communication and lack of complementary markets are some examples of

16
such features. In the absence of complementary markets such as the insurance market, the problem of

income uncertainty cannot be mitigated. If individuals had the option to insure their income, default

would not have been a problem. Besley (1994) pinpoints that another method to mitigate default problems

is by assembling credit histories and by passing sanctions against delinquent borrowers. To assemble

credit histories, information from all lenders must be centralized for which reliable and transparent

communication among lenders is required (Besley, 1994). Since, communication is poorly developed, it

is not possible to assemble credit histories in such credit markets and consequently the risk of default

cannot be minimized.

3.2 Market imperfections identified using the formal literature on

credit rationing

Credit markets diverge from an idealized market because of imperfections that exist in such markets.

Formal literature on credit-rationing helps identify three important market imperfections that ultimately

lead to the exclusion of low-income households from banking services. Following is a discussion of each

of these problems:

3.2.1 Enforcement Problems

In this essay, a pure enforcement problem is defined as a 'situation in which the borrower is able but

unwilling to repay' (Besley, 1994). It can be argued that the issue of enforcing loans is the central

difference between rural credit markets in developing countries and credit markets elsewhere. There are

two types of enforcement problems. First, where the lender attempts to enforce repayment after a default

has occurred. The lender makes such attempts if the benefit reaped exceeds costs attached to enforcement.

These costs include costs of sanctions, seizing collateral and political costs attached with penalizing rich

farmers (Besley,1994). Second, enforcement problems that arise due to lack of property rights. Low-

income borrowers from the community have little or no loyalty towards traditional banks that come from

outside communities. Furthermore, these banks have limited information about potential clients. As a

17
result, banks require collateral and follow the principle of 'no collateral, no business' (Murdoch and

Armendáriz de Aghion, 2005). It may be difficult for the low-income borrowers to offer collateral due to

lack of clear property rights. As mentioned above, credit contracts in industrial and developing countries

include collateral requirements. But in developing countries, particularly in rural markets, it may be

difficult to foreclose on many assets. Besley (1994) points out that in many countries property rights to

land are codified or are often usufructual. This implies that the usefulness of land as collateral is limited.

Furthermore, reclaiming land through courts is not a well-established or routine process.

Murdoch & Armendáriz de Aghion (2005) argue that even with clear property rights, lenders may find it

difficult to seize assets from the very poor for legal and social reasons. Taking resources away from the

very poor may lead to stiff opposition from the community. Even if a low-income borrower was able to

offer collateral, traditional banks would be unwilling to use it to secure loans. Therefore, while these

banks have abundant capital, they lack mechanisms to 'disburse and collect funds profitably in poor areas'

(Murdoch and Armendáriz de Aghion, 2005). This analysis assumes that liability is limited, that is,

borrowers cannot repay more than their current income.

These difficulties of enforcement help explain the use of informal financial arrangements in developing

countries. Besley (1994) cites the use of informal sanctions to persuade individuals to repay loans in

situations where formal banks fail to do so. For instance, delinquent borrowers may be barred from

village ceremonies (Besley, 1994). Such sanctions are based on the assumption that borrowers value

social ties. For this reason, the level of effectiveness of the sanctions depends on the extent to which the

borrowers value relationships. Borrowers who value social ties would be compelled to repay loans when

such sanctions are imposed. In such arrangements, conventional solutions such as physical collateral is

replaced with social collateral that relies on social ties.

18
3.2.2 Imperfections in Information

Imperfect information is available on borrowers to lenders. As a result of imperfect information, problems

arise at three distinct stages (Murdoch and Armendáriz de Aghion, 2005). First, before extending the loan,

the lender may not have reliable information about the quality of the borrower and obtaining information

is costly. Second, after the loan has been granted, the lender does not know with certainty how the

borrower will use the resources. Third, at the end of a project when the investment returns have been

realized, the lender may not be able to verify the 'magnitude of returns' (Murdoch and Armendáriz de

Aghion, 2005). Lenders lack the ability to perfectly monitor the borrower's true profits and as a result the

borrower may be tempted to request a 'reprieve in paying the loan' (Murdoch and Armendáriz de Aghion,

2005) even when the project is highly profitable. This section examines two main categories of

information problems - adverse selection and moral hazard.

3.2.3 Adverse Selection

Adverse selection problems arise before the contractual arrangements take place. As shown by Stiglitz

and Weiss (1981), adverse selection occurs when lenders are unaware of particular characteristics of the

borrowers such as their preferences for undertaking risky projects. Banks attempt to minimize problems

by charging all borrowers exceedingly high interest rates.

At high interest rates, risk-averse or low-risk borrowers drop out of the market. This gives rise to a market

failure as, if the market was efficient these borrowers would have been able to raise funds in the capital

market. Murdoch and Armendáriz de Aghion (2005) illustrate this mechanism with an example.

Assuming there is an economy that only consists of individuals who seek to maximize profits and can

invest $1 in a one-period project. Let us also assume that these individuals do not have wealth of their

own, so they need to borrow to invest in the project. Potential borrowers are heterogeneous, that is, they

can either be 'risky' or 'safe'. A safe borrower invests $1 and earns revenue y with certainty. On the other

hand, a risky borrower invests $1 and earns revenue y with probability of success p , such that 0 < p < 1

19
(Murdoch and Armendáriz de Aghion, 2005). When risky borrowers are successful, they earn higher

profits than the safe borrowers, that is y < y . But when risky borrowers are not successful, they earn

zero profits and cannot repay the loan. For simplicity, it is assumed that both borrowers have identical

expected returns, that is, we assume that riskier borrowers do better than safe borrowers when successful

but perform 'equivalently when returns are adjusted for risk' (Murdoch and Armendáriz de Aghion, 2005).

This implies that p y > y .

Let us assume that the lender is a competitive bank that is committed to breaking even 8 (Murdoch and

Armendáriz de Aghion, 2005). The bank tries to cover its gross cost, k , per unit lent. This gross cost

includes - 1) cost of raising money from depositors, 2) transaction costs that the bank incurs while

administering the loan and 3)the interest rate that is paid to depositors or other suppliers of capital.

Suppose that the low revenue outcome

exceeds the gross cost of capital that is

p y > k and y > k . 9 If there were only

low-risk borrowers, then the bank would

set the gross interest rate, that is the sum of

the interest paid and principal, equal to k

as these borrowers will always repay

(Murdoch and Armendáriz de Aghion,

2005). Competitive pressures would ensure

that banks drive the interest rate down to

Figure 3: Adverse Selection example (Murdoch
and Armendáriz de Aghion, 2005)
equal marginal cost. At this interest rate,

8
This assumption enables us to study the information problems that arise owing to the lack of information and
collateral.
9This assumption ensures that the investment by either borrower is efficient in expectation.

20
the bank breaks even while the borrower makes a profit equal to the difference between the revenue and

the cost of borrowing or

( y − k ). But when risky borrowers apply for loans, the bank would be willing to charge these borrowers

an interest rate that is higher than k to compensate for the additional risk (Murdoch and Armendáriz de

Aghion, 2005). The problem arises if the bank cannot distinguish between safe and risky borrowers. If the

lender knows that a proportion of s of the loans applications are made by safe borrowers while the

remaining 1 − s of the loan applications are made by risky borrowers, then the break-even gross interest

rate of the lender would increase from k to Rl .

Rl is set such that the bank breaks even when the type of borrower that applies for the loan is unknown.

k
This implies that Rl [q + (1 − q ) p ] = k therefore Rl = (Murdoch and Armendáriz de
[q + (1 − q ) p ]

[k (1 − q )(1 − p )]
Aghion, 2005). Rl exceeds k by an amount A = and for this reason, we can write
[q + (1 − q ) p ]

Rl = k + A . By theorem 2 developed by Stiglitz and Weiss (1981), we know that as interest rate

increases, the pool of applicants becomes riskier. Now all borrowers, irrespective of their risk type, pay a

higher rate of interest as the bank is unable to distinguish between safe and risky borrowers. Hence, if Rl

is too high, then safe borrowers drop out of the market. This is an inefficient outcome both type of

borrowers have projects that deserve to be funded. This gives rise to the problem of incomplete markets.

As illustrated in figure 3, when the gross interest rate lies between k + A and y , the bank makes a profit

by lending to the risky and safe borrowers. Assuming that the bank is able to recover its costs, the market

is efficient, with no credit rationing. Even though as seen in figure 3 the profits of the bank are increasing

between k + A and y , the bank would charge the borrowers k + A as we have assumed that the bank

wants to break-even. When the interest rate rises above y , the bank loses the safe borrowers as clients.

Murdoch and Armendáriz de Aghion (2005) believe that a prudent bank at this point would either

21
 k
increase rates up to or reduce interest rates. If the bank chooses to increase its interest rates, then it
p

would recover costs by serving only risky borrowers. Profits would rise again as interest rates are pushed

k y
above . When the gross interest rate increases to even the risky borrowers leave the market
p p

(Murdoch and Armendáriz de Aghion, 2005). At this interest rate, no one is willing to borrow. Stiglitz

and Weiss (1981) stated in theorem 4 that the expected return or profit of the bank is not monotonically

increasing in interest rate which creates the possibility of credit rationing follows. A profit maximizing

k
lender will not voluntarily choose to raise interest beyond where the adverse selection effect
p

dominates. As demand by risky borrowers exists beyond this point, as seen in figure 4, credit rationing

will be the equilibrium which is both inefficient and inequitable (Murdoch and Armendáriz de Aghion,

2005).

The interest rate therefore has two effects. First, it serves 'its usual allocative role' (Besley, 1994) by

equating demand and supply of loanable funds. Second, it affects the average quality of the lender's loan

portfolio. As it impacts quality of the loan portfolio, lenders may not choose an interest rate that clears the

market thereby leading to a rationing equilibrium.

3.2.4 Moral Hazard

The model developed by Stiglitz-Weiss (1981) can be extended to allow for moral hazard. The problem

of moral hazard arises when lenders are unable to observe the actions of the borrowers. It may be

classified as being either ex-ante or ex-post moral hazard.

Ex-ante moral hazard arises after the loan is disbursed but before the returns from the project are realized.

Murdoch and Armendáriz de Aghion (2005) show that limited liability and moral hazard lead to an

inefficient result. To replicate their result, let us assume that, each individual can invest $1 in a one-period

project. Assuming individuals do not have wealth of their own, they need to borrow. Suppose, a borrower

22
has raised a loan, he can either put in effort and make a profit y with certainty or not work at all. If the

borrower does not work, then the borrower makes positive profits with probability p < 1 . Let us assume

that the cost of effort that is incurred by the borrower is c and the gross repayment to the lender made at

the end of the project is equal to R , where R > k and k is the cost of a unit of capital (Murdoch and

Armendáriz de Aghion, 2005). As we have assumed that there is limited liability, R is paid if and only if

the borrower makes a profit. Let us consider the borrower's decision about whether or not to expend effort

on the project:

The net return if he puts in effort is ( y − R ) − c . If effort is not expended then the net return is p ( y − R )

. The borrower therefore expends effort if and only if ( y − R) − c > p ( y − R ) which implies that

R < y −  c  . That is, if the gross return is raised above y −  c  , the borrower will no longer
 1 − p   1 − p 

have an incentive to expend effort and would only hope for a good outcome. In this case, the lender will

suffer the risk of default. To reduce risk in this case, the bank must impose a ceiling on the gross interest

rates.

Now, the cost of funds is k such that y − c > k which implies that there is a net return that is higher

than the bank's cost of capital. In a perfect world, Murdoch and Armendáriz de Aghion (2005) claim that

the borrower would expend effort that is required for success. This result shows that borrowing is ex-ante

efficient but there is no way to force the borrower to put in the required effort. The cost of funds, k is

smaller than y − c but is greater than y −  c  . To break-even, the bank would have to charge an
 1− p 

interest rate that is at least as large as k and will set R such that R > y −  c  . At this point, as
 1− p 

shown above, the borrower will decide to make no effort. Therefore, the bank knows that if it sets interest

rates at a level high enough to cover capital costs, it would lose money since the borrower would shirk. In

this situation the bank decides not to lend. However if the borrower commits to not shirking, the bank

might agree to invest. Such a commitment becomes credible when accompanied with collateral (Murdoch

23
and Armendáriz de Aghion, 2005). Since, low-income households are unable to offer collateral or a

similar incentive, banks do not lend to such borrowers.

Ex-post moral hazard of the 'enforcement problem' refers to difficulties that emerge after the loan is made

and the borrower has invested. The borrower may choose to 'take the money and run' (Murdoch and

Armendáriz de Aghion, 2005). This situation arises when the actions of the borrower are hidden or not

fully observable or when observable, the lender cannot enforce repayment by the borrower. Murdoch &

Armendáriz de Aghion (2005) discuss the extreme case wherein no repayment is legally enforced ex-post

as the returns are not verifiable. In this case, there is no point in granting a loan unless the lender can rely

on some threat not to refinance a defaulting borrower.

To illustrate the notion of ex-post moral hazard, let us assume that $1 is invested and the project is always

successful (Murdoch and Armendáriz de Aghion, 2005). Let us suppose that the project yields y with

certainty. Let us also assume that the borrower has private wealth w that can be used as collateral for the

loan. In case the borrower defaults, the bank would confiscate the borrower's private wealth w . Let the

gross interest rate be R that is fixed such that the lender breaks even when financing the extra cost of the

project. This gross interest rate includes interest rate and the principal amount. The probability with which

default is verified is x , such that x < 1 . The borrower's ex-post payoff is y + w − R . If the borrower

does not repay, his/her payoff is (1 − x)( y + w) + xy , where (1 − x)( y + w) is the borrower's payoff when

s/he is able to 'take the money and run' (Murdoch and Armendáriz de Aghion, 2005).This occurs with

probability (1 − x) . xy is the borrower's payoff when the bank succeeds in catching the borrower and

seizes collateral which occurs with probability x . The borrower takes the money and runs, if and only if

the enforcement constraint, y + w − R > (1 − x)( y + w) + xy is satisfied, that is if it is more costly to

repay the loan. If a borrower is unable to provide collateral (w = 0 ) , then y − R > (1 − x)( y ) + xy . This

can be simplified to y − R > y , which is not possible as R > 0 . Hence, the higher payoff that results

24
from not repaying acts as an incentive to such a customer to take the money and run. As traditional banks

are aware of this incentive, customers who are unable to offer collateral find it difficult to acquire loans.

3.2.5 High transaction costs

There are high transaction costs attached to micro-loans. Gonzales (2010) points out that smaller the loan

size, the greater is the operating cost per dollar in portfolio outstanding. The costs may not be small,

especially when no collateral is offered and legal enforcement mechanisms are weak. These operating

costs include costs necessary to 'deliver small loans including administrative and personnel expenses'

(Gonzales, 2010). Braverman and Guasch (1989) estimate that the administrative costs associated with

handling small loans ranges from 15 to 40 percent of loan size. For large commercial banks such

transactions are therefore unfavourable.

Besley (1994) posits that while such costs are high, they may not necessarily lead to exclusion of

borrowers from the credit market. Whether or not there is an inefficiency depends on whether human

capital and other factors that determine the price of loans are priced at their true economic costs. In case

these factors are not priced at their true values, high transaction costs could indicate inefficiency.

4 Government Intervention to increase welfare

The Stiglitz-Weiss model (1981) described above leads to the unambiguous policy conclusion that

lending will be too low. For this reason, governments in developing countries intervened to increase

welfare by increasing lending in the rural credit market. Policies were introduced to expand lending to

offset the negative externality created by risky borrowers for the safe borrowers thereby increasing

welfare (Besley, 1994).

4.1 Policies introduced to increase lending

Lenders are unwilling to lend to low-income borrowers for the reasons stated above that include

information and enforcement problems along with high transaction costs. To increase lending, policies

25
introduced by governments in developing countries focused on solving two key problems - first, the lack

of collateral and second, the problem of high transaction costs and inherent risks. Following is the

discussion of policies introduced by governments in developing countries to solve these problems and the

impact of intervention on the economy.

4.1.1 Lack of collateral

Governments can help to solve the problem of collateral by 'improving the codification of property rights'

(Besley, 1994) for example, by taking steps to improve the registration of land. But it is debatable

whether these actions would have the desired impact. In the short run, attempts to 'codify rights may lead

to disputes' (Besley, 1994) and 'land insecurity' (Besley, 1994). Besley (1994) points out rightly that such

attempts by the government pose ethical questions on the extent to which developing countries should be

encouraged to adopt western legal notions of property. But as highlighted before, Murdoch and

Armendáriz de Aghion (2005) argue that even with clear property rights, lenders may find it difficult to

seize assets from the very poor. The relationship between improved property rights and its impact on the

credit market is therefore still ambiguous and requires further research.

4.1.2 High transaction costs and inherent risks

Large state agricultural banks were given the responsibility to allocate funds (Murdoch and Armendáriz

de Aghion, 2005). Heavy subsidies were deployed to encourage traditional banks to enter markets that

were deemed as being unprofitable owing to high transaction costs and inherent risks. Subsidies were also

used to keep interest rates low for low-income borrowers. Policymakers hoped that by providing

subsidized credit, farmers would be encouraged to irrigate, apply fertilizers and technologies to increase

land productivity. This would lead to an increased demand for labour and therefore increase agricultural

wages.

Murdoch and Armendáriz de Aghion (2005) believe policies that focused on providing subsidized credit

serve as the perfect example of 'good intentions gone awry'. They cite two examples to substantiate their

26
claim. First, in Philippines where before the reform in 1981, interest rates were capped at 16 percent while

inflation rate was around 20 percent that led to a negative interest rate in the market. This negative

interest rate created an excess demand for funds in the market. Suppliers of these funds were pressurized

to allocate loans to 'politically favoured residents rather than to target groups' (Murdoch and Armendáriz

de Aghion, 2005). On the other hand, the interest rate that was offered to rural depositors was as low as 6

percent per year which translated into a real interest rate of negative 14 percent. For this reason, the

incentive to save was absent which added to the existing pressure on the limited supply of funds. By

providing loans at low rates of interest, David (1984) concludes that income distribution was worsened.

Only a few well-off farmers received the bulk of cheap credit. Interest rates were not allowed to 'reflect

costs of financial intermediation' (David, 1984) and as a result, 'wealth and political power' (David, 1984)

replaced 'profitability as the basis for allocating credit' (David, 1984). McKinnon (1973) blames such

policies for creating financial repression rather than delivering access. Second, the Integrated Rural

Development Program (IRDP) that was introduced in India to provide subsidized credit. In this program,

credit was allocated according to 'social targets' that 'pushed 30 percent of the loans towards socially

excluded groups such as members of '"scheduled" tribes or caste' (Murdoch and Armendáriz de Aghion,

2005) and 30 percent towards women. Murdoch and Armendáriz de Aghion (2005) criticize the fact that

capital was allocated according to a series of 'nested planning exercises' (Murdoch and Armendáriz de

Aghion, 2005). Village plans aggregated to block plans that aggregated to district plans and then state

plans. Even though subsidies given using this system grew to $6 billion, they did not generate good

institutional performance. According to Pulley (1989), repayment rates fell below 60 percent and the

recovery rate to 31 percent. Due to the declining institutional performance, IRDP failed to be achieve its

objectives.

4.2 Criticism of government intervention

Critics of government-led development banks like IRDP base their argument on five problems that

emerged in the market due to the introduction of such policies. Firstly, credit was 'directed to particular

27
ends' (Murdoch and Armendáriz de Aghion, 2005) that were favoured by policymakers. This proved to be

disastrous as policymakers could be influenced or even pressurized to direct credit towards a particular

subgroup, to encourage the use of certain technology or manufacture a particular good. In the absence of

influence or pressure to direct resources towards a particular end, policymakers could base

recommendation on miscalculated benefits or costs. When combined with cheap credit, this created

'havoc in the rural financial market and undermined the attempts to reduce poverty' (Murdoch and

Armendáriz de Aghion, 2005). Secondly, banks became 'flabby' (Murdoch and Armendáriz de Aghion,

2005) due to the formation of monopolies and the removal of 'market tests' (Murdoch and Armendáriz de

Aghion, 2005). Critics believe that banks would have been better off without such subsidies. Thirdly, in

the absence of subsidized banks, the market interest rates acted as a filter through its rationing

mechanism. Only borrowers with projects worthy of investment were willing to pay for credit (Murdoch

and Armendáriz de Aghion, 2005). Subsidies destroyed this rationing mechanism as credit was allocated

on the basis of social concerns and politics rather than on the basis of efficiency. Fourthly, Murdoch and

Armendáriz de Aghion (2005) posit that due to the steady flow of capital from the government, the

incentive to collect savings deposit was diminished. As a result, banks did not provide households with

savings schemes and households lacked efficient ways to save. Lastly, the government itself became

responsible for the enforcement problem since government-backed credit programs experienced the worst

default rates while pursuing social objectives. In various Indian states, debt-forgiveness declarations were

made binding on private creditors. Banks that were owned by the state were pressured to forgive loans

'just before election' (Murdoch and Armendáriz de Aghion, 2005). The powerful were granted access to

cheap funds that were meant for the low-income borrowers. The incentives to repay the loan decreased

when borrowers forecasted that the bank may forgive debt. The government sent out wrong signals by

bailing out bankrupt credit programs and by engendering expectations that bad behaviour would be

rewarded by debt being forgiven. Through such signals, the government lost credibility of imposing

sanctions on delinquent borrowers. Borrowers took loans with the 'well-founded expectations' (Besley,

1994)that they will not be obliged to repay them. The lack of sanctions weakened incentives for

28
borrowers to invest in good projects, instead strengthened the 'incentive for rent seeking' (Besley, 1994).

Braverman and Guash (1986) estimate that credit programs in Asia, Africa, Middle East and Latin

America have ended up with default rates between 40 percent to 95 percent. When default rates are so

high, borrowers view credit programs as 'providing grants rather than loans that must be repaid' (Murdoch

and Armendáriz de Aghion, 2005).

5 Microfinance

Microfinance, the concept of lending to low-income borrowers who are excluded from the traditional

banking sector, has received attention from policy makers and development practitioners. Between 1997

and 2005, the number of microfinance institutions (MFIs) "increased from 618 to 3133" (Hermes and

Lensink, 2007). During this period, the number of people who received credit "rose from 13.5 million to

113.3 million"(Hermes and Lensink, 2007). While the spread and reach of MFIs worldwide is

noteworthy, what appears to be most surprising, in light of the discussion above, is the survival of such

institutions. In spite of the imperfections that exist in the rural credit market in developing countries,

microfinance institutions (MFIs) have flourished in the breach of it all.

Grameen Bank, the MFI established by Muhammad Yunus in 1983, reported a repayment rate of 92%

which is significantly high relative to other lending institutions in Bangladesh that reported a repayment

rate of 75% (Kowalik and Martinez-Miera, 2010).This success of the Grameen Bank model, encourages

traditional banks to re-examine their approach to the rural credit market. This model does not prescribe

methods or means to solve information and enforcement problems that plague such credit markets. But a

diverse set of non-traditional mechanisms within the microfinance model allow MFIs to cope with these

problems. These mechanisms underlie the high repayment rates achieved in comparison to the traditional

banking sector. Group lending with joint liability, the use of substitutes for collateral, dynamic incentives

and regular repayment schedules are examples of such mechanisms. Following is a discussion of how

each of these mechanisms circumvent the enforcement and information problems.

29
5.1 Group Lending

Figure 4: Loan Distribution System, (Shukran and Rahman, 2011)

Microfinance is seen as a solution to the age-old challenge of finding a way to combine the bank's

resources with the 'local informational and cost advantages of neighbours and moneylenders' (Murdoch

and Armendáriz de Aghion, 2005).The Grameen Bank adopted a unique system where potential

borrowers voluntarily form groups consisting of five. At first, the use of groups was implemented to

benefit from economies of scale. But Yunus and his associates slowly realized that such groups provided

a method to reduce costs of monitoring, screen borrowers and enforce debt repayments (Murdoch and

Armendáriz de Aghion, 2005). To maximize the benefits of group lending, a 'Loan Distribution System'

was developed as seen in figure 4. Based on this system, initially, only two members are allowed to take

a loan. If all instalments are paid on time, the next two borrowers can apply for loans after four to six

weeks. Finally, the fifth member receives the loan. This pattern is known as 2:2:1 staggering (Murdoch

and Armendáriz de Aghion, 2005). These groups of five meet weekly with seven other groups, so that

bank staff meet forty clients at a time. Such contracts benefit from local information and rely on local

enforcement mechanisms.

Through group lending with joint liability, enforcement problems can be reduced. If serious repayment

problems emerge, all group members are cut off from future borrowing. Borrowers who do not want to

30
lose access to microcredit loans accept the possibility of bailing out fellow group members in times of

need (Murdoch, 1999). Therefore, group borrowing gives rise to joint liability. When the group repays on

time, borrowers are offered a larger loan that is repayable in the next 'loan cycle' (Murdoch, 1999).

Eventually, if the relationship between Grameen and the borrowers continues, credit histories are built.

In principle, the adverse selection problem can be mitigated by group lending with joint responsibility.

Murdoch and Armendáriz de Aghion (2005) pinpoint two mechanisms in force through group lending.

First, borrowers select their group members. Individuals are encouraged to form groups voluntarily. As

borrowers are faced with the prospect of joint responsibility for loans, an informal sorting mechanism is

established. Group-lending schemes provide incentives for similar types to group together (Murdoch,

1999). Safe borrowers prefer to be grouped with other safe borrowers and consequently, risky borrowers

are forced to stick together. Consequently, the lender can distinguish between the risky and safe groups.

Second, there is joint liability. Investments by risky borrowers are more likely to fail than investments by

safe borrowers. Under the system of joint responsibility, risky borrowers have to pay for their defaulting

peers more often than the safe borrowers to ensure that they can take a bigger loan in the future. As a

result, there is a transfer of risk of adverse selection from the bank onto the borrowers. These borrowers

exploit an intangible resource, local information. While the bank continues to remain ignorant of the

borrower's 'type' and offers the same contract, repayment is now certain owing to the joint responsibility

and the 'sorting mechanism' (Murdoch and Armendáriz de Aghion, 2005). Banks are now better insured

against default and are therefore able to reduce average interest rates for both risky and safe borrowers

while making profits. These lower interest rates attract those safe borrowers to re-enter the market who

had earlier decided to drop out of the market. As a result, the market failure caused by adverse selection is

mitigated and the problem of credit rationing is to this extent, circumvented.

Group lending with joint responsibility has the potential to get around both ex-ante and ex-post moral

hazard problems in lending. It creates incentives for the borrowers to choose safe projects and not take

risks that undermine the bank's profitability (Murdoch, 1999). While this is good for the bank, it 'saddles

31
borrowers with extra risk' (Murdoch, 1999). They can inflict penalties upon fellow borrowers who have

chosen excessively risky projects. Since members are affected by the actions of their group members,

they will take steps to punish those members who put in little or no effort. Monitoring and enforcement

costs are therefore borne by borrowers rather than the bank. As the bank is guaranteed revenues due to

this mechanism, it can afford to lend to clients at a lower interest rate (Murdoch, 1999). By exploiting the

ability of neighbours to enforce contracts and monitor each other, neither of which the bank can do, the

group-lending contract offers a way to lower equilibrium interest rates, raise expected utility, and

expected repayment rates (Murdoch, 1999).

5.2 Substitutes for collateral

MFIs use substitutes for collateral to reduce their exposure to risk. The Grameen model requires

borrowers to contribute 0.5 percent of every unit borrowed to an 'emergency fund' (Murdoch, 1999). This

fund provides insurance in case of default, death, disability etc. in amounts proportional to the length of

membership. Further, an additional 5 percent of the loan is taken out as 'group tax' that goes into the

group fund account. This is disbursed among the group as zero interest rate loans with fixed terms

(Murdoch, 1999). These 'forced savings' can be withdrawn upon leaving, after the bank has deducted the

amount that is owed. In effect, the funds serve as a form of partial collateral (Murdoch, 1999).

Murdoch (1999) explains how 'social assets' lie at the heart of these enforcement mechanisms as they rely

on informal insurance relationships and threats. These range from 'social isolation to physical retribution'

(Murdoch, 1999) that facilitate borrowing for households that are unable to provide collateral. Low-

income households have little or no physical assets and for this reason, microfinance programs revolve

around such social assets.

5.3 Dynamic Incentives

Dynamic incentives are used to reduce problems of moral hazard. Programs begin by lending small

amounts and then upon satisfactory repayment, the loan size can be increased (Murdoch, 1999). Two facts

32
can be exploited to overcome information problems and improve efficiency, first, the repeated nature of

interactions and second the credible threat to cut off financing in case of non-repayment. The advantage

of repeated interactions and progressive lending is that the lender can test borrowers with small loans at

the start. Lenders can develop relationships with borrowers and screen out the worst prospects before

expanding loan scale (Murdoch, 1999). These incentives are enhanced if borrowers can anticipate a

stream of increasingly larger loans. But it is crucial that MFIs that rely on these incentives maintain low

or competitive interest rates. If the interest rates are not competitive, the borrower will be tempted to

default and take a loan from a competitor at a lower interest rate. Hence, competition diminishes the

power of dynamic incentives (Murdoch, 1999).

5.4 Regular repayment schedules

Another mechanism that is used in microfinance credit contracts by the Grameen Bank is that repayment

starts immediately after disbursement. Murdoch (1999) shows that terms for a year-long loan are likely to

be determined by adding the interest rate and principal due and dividing the sum by 50, and starting

weekly collections a couple of weeks after the disbursement. This mechanism is used to distinguish

between disciplined and undisciplined borrowers. Loan officers and group members receive early

warning about emerging problems. They can take steps to get hold of cash flows before they are

consumed or diverted in another direction (Murdoch, 1999).

6 Conclusion

The central lesson of the theory of credit rationing is that the expected return of the bank is not

monotonically increasing in interest rate due to asymmetric information. Consequently, the credit market

is characterized by a rationing equilibrium which is inefficient. By applying the theory of credit rationing,

imperfections that exist in credit market come to the fore. Enforcement problems, information problems

and high transaction costs are imperfections that plague the credit market. These imperfections are

accentuated by two features of the rural credit market in developing countries. Firstly, the lack of

33
collateral and secondly the underdeveloped complementary markets such as the market for insurance. The

inefficiency of the credit market highlighted by this model created a need for government intervention. As

a result, governments in developing countries attempted to improve the codification of property rights to

solve the problem of collateral. To increase welfare by increasing lending, governments provided

subsidized credit. Even though these policies were implemented with the best of intentions, they did more

harm than good. Against this background, microfinance has created an economic and social impact in

spite of challenges posed by the rural credit market in developing countries. A number of non-traditional

mechanisms such as group lending with joint liability, use of substitutes of collateral, dynamic incentives

and regular repayment schedule have helped MFIs to cope with information and enforcement problems.

The theory of credit-rationing allows us to identify problems that the traditional banking sector faces in

credit markets. Significant features of the rural credit markets in developing countries that distinguish

them from other credit markets, intensify these problems. As a result, worthy borrowers are financially

excluded. MFIs, that are set in rural areas of developing countries, aim to provide small loans to these

very borrowers. By deconstructing and analyzing aspects of microfinance, we can form an understanding

of how MFIs minimize inherent problems associated with their setting. Therefore, the economic rationale

behind microfinance provided by the literature on credit-rationing is limited to the identification of

challenges posed by lending to low-income borrowers. This economic theory provides a limited

explanation of microfinance. Apart from credit, microfinance provides a full range of financial services

such as savings and insurance services. It relies on social capital and encourages entrepreneurship and

innovation among its clients to bridge the schism between 'financially minded donors and socially minded

programs' (Murdoch, 2000). These aspects of microfinance have yet to be adequately explained by the

economic-theoretic literature in general and the formal literature on credit-rationing in particular.

34
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