Credit Court

Credit market in developing economies
& the Micro-nance revolution ?
Karine Marazyan - URN LASTA
February 20, 2024
Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 1 / 71

Motivations and Objectives
Plan
Motivations
Objectives
Why do we observe (locally) high interest rates ?

To manage the risk of default of borrowers
Why do we observe credit rationing ?

To manage the risk of an adverse selection
To manage borrowers' risk of moral hazard on eort
Information asymmetries and mitigating strategies ? A summary
Economics of group lending

Principles
To overcome adverse selection
To overcome moral hazard
Limits of group lending
Beyond group lending ?
References

Motivations and Objectives Motivations
Plan
Motivations
Objectives



Principles
References

Motivations and Objectives Motivations
Motivations
See Ted Talks

Motivations and Objectives Objectives
Plan
Motivations
Objectives



Principles
References

Motivations and Objectives Objectives
Objectives
I Why do we observe (locally) high interest-rates ?
I Why do we observe credit rationing ?
I Why do group-lending work ?
I Beyond group lending

Plan
Motivations
Objectives



Principles
References

Potential explanations (1)
I Lending monopoly ?
I Empirically : not supported (at best, local monopoly)
I Interventions consisting in increasing competition did not led necessarily to a
decrease of interest rates
I Theory : exclusivity justies high implicit interest rates, not high explicit ones
(cf rational for interlinkages)




I Reect the high costs of acquiring capital (deposits to pay), the high
opportunity cost of capital, of high transaction costs (costs associated with
screening the borrrowers, monitoring the use of loans, and enforcing
repayments) ?
I To adjust the risk of default ?

Why do we observe (locally) high interest rates ? To manage the risk of default of borrowers
Plan
Motivations
Objectives



Principles
References

Denition
I On capital and/or interest
I Involuntary default
I Strategic default (in contexts with weak legal systems)
I Ex-ante: risk relatively high

Setting
I Consider the moneylender k

I L = amount he lends out
I r = the opportunity cost of his lent fund (the same for every moneylender)
I i = the interest rate charged
I p exogenous probability that one dollar lent out is repaid back
I Expected prot of k : p(1 + i)L − (1 + r)L
Question : how is i xed ?

Solving for i ?
I The market is competitive = many moneylenders => expected prot in

equilibrium = 0
1+r
I p(1 + i)L − (1 + r)L = 0 => i = −1
p
I p= 1 ?
I i=r
I p< 1 ?
I i>r
I Ex. : if p=50% and r=10%, then i= ?

Solving for i ?

equilibrium = 0
1+r
I p(1 + i)L − (1 + r)L = 0 => i = −1
p
I p= 1 ?
I i=r
I p< 1 ?
I i>r

Solving for i ?

equilibrium = 0
1+r
I p(1 + i)L − (1 + r)L = 0 => i = −1
p
I p= 1 ?
I i=r
I p< 1 ?
I i>r

Extensions (p no more exogenous)
I What if p = p(L) with p(L) > 0 ?
I What if p = p(T ype of project) (one-shot need versus repeated needs) ?
I => Certain types of loans will not be observed in equilibrium

Extensions (p no more exogenous)
I What if p = p(L) with p(L) > 0 ?
I What if p = p(T ype of project) (one-shot need versus repeated needs) ?
I => Certain types of loans will not be observed in equilibrium

Limits
In Pakistan, Aleem (1990) similarly nds that loans and interest are not
always paid on time, but the cost is typically a matter of several months of
delay in retrieving funds rather than a full loss. Similarly, a survey in Ghana
showed that 70 to 80 percent of informal lenders had perfect loan recovery
rates in 1990 and 1991 [Armendariz de Aghion and Murdoch, 1990]
=> Institutional arrangements (yet to be described) allow for low default rate
=> High interest rate exist for another reason

Plan
Motivations
Objectives



Principles
References

Denition
I refers to a situation in which, at the going rate of interest in the credit

transaction, the borrower would like to borrow more money, but he is not
permitted by the lender [Ray, 1998]

Potential explanations
I To manage borrowers' risk of moral hazard on eort
I To manage the risk of an adverse selection

Why do we observe credit rationing ? To manage the risk of an adverse selection
Plan
Motivations
Objectives



Principles
References

The problem [based on Stiglitz and Weiss, 1981]
I Not all borrowers bear the same amount of inherent risk
I Some may be simply more prudent, more conservative, better insured; others
may be risk-loving, poorly disciplined, face competive claims on their funds,
etc.
I inherent versus actions taken once the contract is signed that increase or
decrease risk
I Moneylenders cannot identify risky borrowers from safe ones
I Consequences ?

Setting (1)
I Individuals seek to maximize prots
I Individuals can invest 1$ in a one period project; no initial wealth, they need
to borrow if they want to invest
I Potential borrowers are heterogeneous: safe or risky type
I Safe type: 1$ brings y0 with certainty

00
I Risky type: 1$ brings y with probability p∈ [0,1] with y 00 > y 0 and 0 with
probability 1−p
I But expected returns are similar y 0 = p ∗ y 00
I No possibility to identify the type

Setting (2)
I Moneylenders/banks : competition <=> prot (return of x$ lent - cost of

x$ lent) =0
I If no risk & given competition: return of x$ lent =k (opportunity cost)
I If risk: return of x$ lent =k + risk premium
I Value of the risk premium ?

Setting (3)
I Suppose moneylenders/banks know only the proportion of risky individuals

in the population: q proportion of loans demand from safe borrowers; 1−q
proportion of loans demand from risky borrowers.
I Given competition : q ∗ Rb + (1 − q) ∗ p ∗ Rb = k
k(1 − q)(1 − p)
I Risk premium =
q + (1 − q)p



Applications
I Moneylender/bank : k = 1,40 $ * (size of investment)
I Individuals :
I Reservation wage : 45$ / month
I Project : initial investment = 100 $

Project : return for a safe borrower = 2 $ each $ => Gross income = 200 $
I A safe borrower will borrow if 200 > 100 + 40 + 45 : YES

Project : return for a risky borrower
I = 2,22 $ each $ with probability 0,9 => Gross income = 222 $ with
probability 0.9; 0 otherwise
I Expected gross income = 200 $
I A risky borrower will borrow if 0,9*222 > 0,9(100 + 40) + 45 : YES

If q = 0,5, will the bank oer them loans ?
k(1 − q)(1 − p)
I Risk premium = = + 0,074
q + (1 − q)p
I Interest rate = 1,474 $ for each $ lent
I Both safe and risky borrower will borrow
=> No ineciency issue

If q= 0,5 and gross income =267 with p =0,75 , will the bank oer them loans ?
k(1 − q)(1 − p)
I Risk premium = = + 0,2
q + (1 − q)p
I Interest rate = 1,6 $ for each $ lent
I Ecient for the safe borrower to borrow if 200 > 160 + 45 : NO !
I Ecient for the risky borrower to borrow if 0,75*267 = 200 > 0,75*160 +
45 : YES !
=> Ineciency issue since worthy borrowers (if no risk) will not be able to borrow
(given risk)

Challenges
I Only risky borrowers borrow BUT 0,75*160 < 140 => bank does not cover
her costs
I Bank increases further her interest rate to cover her costs (to 1,87)
=> Ineciency issue = worthy borrowers do not participate in the credit market


Comments
I The presence of safe borrowers (q >0) allows a decrease of the average

interest rate charged in a risky environment (safe borrowers subsidy risky
ones); yet some safe projects may not be funded
I Raising interest rates does not necessarily increase prots in a linear way,
since it changes the risk composition of the lender's portfolio
I Might explain why some interest rates are not observed
Solutions?
I Collateral ?
I The benet of group lending ?
I The benet of exchanging with someone with whom long-term relationships

are established ?

Why do we observe credit rationing ? To manage borrowers' risk of moral hazard on eort
Plan
Motivations
Objectives



Principles
References

Denition
I When unobservable actions or eorts are taken by borrowers after the loan
has been disbursed but before project returns are realized. These actions
aect the probability of a good realization of returns.

Setting (1)
I Individuals seek to maximize prots
I Individuals can invest 1$ in a one period project; no initial wealth, they need
to borrow if they want to do so
I Once the loan is obtained: has to pay back R>k the cost of a unit of
capital if y>0 (limited liability)
I Once the loan is obtained: two choices
I Expend eort: y>0 with certainty but it costs c (utility cost, opportunity
cost, etc.)
I Not provide eort: y>0 with p< 1

Condition under which the borrower will provide the eort ?
I Net return if eort is provided : (y − R) − c

I Net return if eort is not provided : p(y − R)
c
I Eort will be provided if (y − R) − c − p(y − R) > 0 <=> R < y −
1−p
=> ex-ante moral hazard leads to cap interest rate; otherwise incentive to shirk

Will the bank lend money ?
I Ecient to lend if k < y−c in a perfect world (1)
c
I Ecient to lend if k < y− in a world with risk of shirking (2)
1−p
I If (2) not veried, then no money lent (since increased interest rate raises
incentives to shirk) while in a perfect world it would have been ecient

Solution ?
I Increase the cost of shirking
I Collateral ?
I The benet of group lending ?
I The benet of exchanging with someone with whom long-term relationships

are established ?

The problem with collateral valued at w < k

I If shirks : the borrower looses w and the lender gains w < k : not enough to
cover its costs
I But risk of loosing collateral modies incentives to shirk
I (y − R) − c − [p(y − R) + (1 − p)(−w)] > 0

the borrower will not shirk if
c
<=> R < y + w −
1−p
I => cap-interest rate is higher ; more bank able to lend ? (a market may
emerge)
If w > k , there are incentives to lend despite information asymmetries

To sum up
I Interest rates have a multiple functions
I (a) It is a price, and
I (b) Is is a direct screening instrument (cost of acquiring information on

borrowers)
I (c) Is is a an indirect screening instrument (at higher interest rates, only risky
borrowers demand loans)
I (d) Is is a device helping to maintain incentives to provide eort, to not

strategically default
I >> credit rationing, market segmentation (along lenders' direct costs of

screening, monitoring)

Why do we observe credit rationing ? Information asymmetries and mitigating strategies ? A summary
Plan
Motivations
Objectives



Principles
References

Information asymmetries and mitigating strategies (1)?
On the benet of having capital available as collateral (or how poverty begets
poverty)
I On the benet of clarifying property rights over some existing capital (H. de
Soto (2000))
I On the benet of implementing court systems to enforce these rights
I Aboala, Noya, Rius, 2014, Contract Enforcement and Investment: A

Systematic Review of the Evidence, World development
I Even if the collateral cannot be sold (high transaction costs) by the
bank/moneylender, a bank/moneylender may still ask to keep the land title
so as the farmer cannot ask for a credit at dierent places (and reduce the
risk of default role of new technology and ngerprinting )
>> Role of government / public interventions

Information asymmetries and mitigating strategies (2)?
In the absence of (credible) collateral
I Non-default choice enforced by expected repeated interactions or by

reciprocity
I On the benet of exchanging within the kin group (relationships are expected
to be long-term ones)
I On the benet of lending to groups ?
I Incentives for interlinking contracts (Braverman and Stiglitz, 1982)

Plan
Motivations
Objectives



Principles
References

Economics of group lending Principles
Plan
Motivations
Objectives



Principles
References

Economics of group lending Principles
Group lending: principles
Grameen-style group lending
I The lender requests potential borrowers to organize themselves into groups
I Timing : 2 members of each 5 person-group receive rst their loans; if their

loans are repaid in time, 4/6 weeks later, 2 other members receive their
loans; if their loans are repaid in time, the last person - the chair group -
receives his loan
I If everything goes well: borrowers of the group are oered a larger loan
repayable in the next loan cycle (enabling productive investments)
I If something goes bad : either the chair-group pays for the member who
defaults so as she within this group could access to a loan in the future;
or she does not and the group will not access to a loan in the future

Economics of group lending To overcome adverse selection
Plan
Motivations
Objectives



Principles
References

Group lending: to overcome adverse selection (1)
Adverse selection: recall of the issue
I Mix of risky and of safe borrowers
I Safe borrowers subsidize risky borrowers; interest rate lower than in the case
with risk; but still above the one with no risk
I Risk that safe borrowers are excluded from the market >> credit rationing
How does group lending help overcoming this issue?

Incentives under group lending
I If the lender does not know each borrowers' type; borrowers know
I Safe borrowers match with safe borrowers; risky borrowers have no other
choice than matching with risky borrowers
I Projects of risky borrowers fail more often, but, because of the risk of being
denied futur access to credit, risky borrowers have now incentives to repay for
their defaulting partners
I => Default risk for the lender decreases => average interest rate decreases
=> safe borrowers pushed out of the market have incentives to re-enter the
market
I The lender has transferred the risk to the risky borrowers themselves

Formally
I Groups are made of 2 persons; persons max their expected income (risk
neutral)
I One period project requiring 1$ of investment
I q safe borrowers; 1−q risky borrowers in the population ; borrowers know

each other's types
I For a safe type : 1$ => y 0 $ with certainty; for a risky type: 1$ => y 00 > y 0
$ with p < 1; 0 otherwise;
I We assume py 00 = y 0

Table: Expected income for borrowers in each type of grouping
partner
safe risky
borrower safe (y'-R) p(y'-R)+(1-p)(y'-R-T)
risky p(y-R) p2 (y-R)+p(1-p)(y-R-T)
I (y 0 − R) always > than p(y 0 − R) + (1 − p)(y 0 − R − T ), so a safe will prefer

matching with a safe
I Risky type prefers matching with a safe type; however the safe type will
accept if the risky type gives (1 − p)T as a compensation; as this cost, the
risk type then prefers matching with a risky type
I => Group lending leads to assortative matching

Value of interest rate R charged by the lender under group lending ?
I With interest rate R= cost of mobilising 1$ + risk premium


I Lender's prot = 0 <=> return = cost
I Return from group lending = proba to get back on average R from each
observed group
I Assume population = (s, s, r, r, r, r, r, r) ; so q= 1/4 of the population
I The potential 2 person-groups are: (s, s); (r, r); (r, r); (r, r); then (s, s) = 1/4
of the population made of groups =q
I So, return = qR + (1 − q)(p2 R + p(1 − p)(R + T ))
I Cost = k+ risk premium
I Solving for qR + (1 − q)(p2 R + p(1 − p)(R + T )) = k , we show that the risk

k(1 − q)(1 − p) − (1 − q)(1 − p)pT
premium =
q + (1 − q)p
I => The risk premium to charge if adverse selection under group lending <
the risk premium charged if adverse selection and individual lending

Application
I Reservation wage = 45$

I An investment project supposes borrowing =100$ ; y'= 2 $ each $ lent ;
y = 2.67 $ each $ lent with p= 0.75 and 0 otherwise
I It costs 1.4 $ to the lender to raise 1$
I In the population q = 0.5

I Value of the risk premium ?
I ! The value of the risk premium is determined with the value of T

I To determine the risk premium and T , we need a second equation which is a
00
participation equation: E(y ) − R = T

Answer
I T = 45 $
I R = 1.55 $

Conclusion
I No need for the bank to know each borrower's type; assortative matching
makes the job; this reduces the average interest rate and thereby the extent
of ineciency on the credit market

Economics of group lending To overcome moral hazard
Plan
Motivations
Objectives



Principles
References

Group lending: to overcome ex-ante moral hazard
Intuition
I Family/communities ties = social collateral
I Recall the eect of providing a collateral on interest rate and on incentives to

schrink and to lend

Group lending: to overcome ex-post moral hazard
I Peer monitoring => income realization observed by peers => less easy to
run with the income telling the project has failed
I The incentive to monitor comes from the joint responsability in case one
defaults

Group lending: to overcome moral hazard
Readings
I Stiglitz, 1990, Monitoring and Credit markets, The Wold Bank Economic
Review
I Ghatak and Guinnane, 1999, The Economics of Lending with Joint Liability,
The Journal od Development Economics

Economics of group lending Limits of group lending
Plan
Motivations
Objectives



Principles
References

Limits of group lending (1)
I What if monitoring is costly, and therefore, imperfect ? Once this cost is

taken into account, to what extent group lending is more ecient than
another type of credit contract ?
I On the benet of mobilizing social norms that applies within social groups,
and therefore of lending to group whose members know each other
I On the cost of lending to groups made of family members : the credibility of

the exclusion sanction (and of collective punishment) ?
I On the cost of lending to groups made of persons who know each other: the
risk of collusion ?
I Pro / Cons group lending when groups are made of individuals who know each
other ? See Laont and Rey, 2003

Limits of group lending (2)
I The cost of punishment may be high (the cost of excluding peers because of
another one has defaulted eventually for a reason beyond his control ).
Once this cost is taken into account, to what extent group lending is more
ecient than another type of credit contract ? (See Rai ad Sjostrom, 2004)
I On the benet of gradual monitoring ...
I From Grameen Bank to Grammen Bank II
I Risk transfer and risk-aversion

Plan
Motivations
Objectives



Principles
References

Repayment schedule: what is optimal ?
I Lenders often expect loans to be paid in small installments, starting soon

after the initial disbursement. Rational ?

`Silwal (2003) also notes the correlation between repayment troubles and the
frequency of required installments. He compares repayment performance in nine
village banks in Nepal and nds that 11 percent of loans were not repaid by the
end of the loan period when installments were weekly, while twice that rate (19.8
percent) were delinquent when loans were paid in a single lump-sum payment at
the end of the loan's maturity (which was generally 34 months). Similarly, when
BRAC in Bangladesh experimented with moving from weekly repayments to
twice-per-month repayments, delinquencies soon rose, and BRACjust like
BancoSolquickly retreated to its weekly scheme.'

I It creates an early warning system
I It helps the bank select less risky clients (but then, why not do estimate
repayment capacity based on household income?)
I For borrowers that have diculty saving, the frequent repayment schedules
can help in holding income (but then, loan products become like saving
products: are saving constraints the real problem ?)
I How impose regular repayment schedules in areas focused on highly seasonal

occupations like agricultural cultivation ? (Grameen Bank II maintains weekly
repayment schedules but allowing loan ocers to vary the size of weekly
installments according to season)

References
Plan
Motivations
Objectives



Principles
References

References
References
I Ray, 1998, Development Economics, Princeton
I Armendariz de Aghion and Murdoch, 1990, The Economics of Micronance,

MIT press
I Ho and Stiglitz, 1998, A symposium issue on imperfect information and

rural credit markets, World Bank Economic Review

References
Selection of empirical work
I McMillan and Woodru, 1999, Interrm relationships and informal credit in

Vietnam, QJE
I Fafchamps and Minten, 2002, Returns to social network capital among

traders, Oxford economics papers
I Greif, A. , 1993, Contract Enforceability and Economic Institutions in Early

Trade: The Maghribi Traders' Coalition, AER
I Derksen, 2015, Discrimination in Informal Credit Markets: Experimental

Evidence from India, mimeo
I Leeson, 2007, Trading with Bandits, Journal of Law and Economics
I Kranton and Swamy, 1998, The hazards of piecemeal reform: british civil
courts and the credit market in colonial India, JDE

References
Selection of empirical work (2)
I Gomez and Santor, 2008, Does the micronance lending model actually work
?, The whitehead journal of diplomacy and international relations
I Banerjee, Duo, Glennerster, Kinnan, 2014, The miracle of micronance ?

evidence from a randomized evaluation, mimeo
I Fafchamps, 2006, Spontaneous markets, networks, and social capital:

Lessons from Africa, in Institutional Microeconomics of Development edited
by Besley and Jarayaman
I Aboal, Noya and Nius, 2014, Contract Enforcement and Investment: a

Systematic Review of the Evidence, World Development
I Besley, Coate, and Loury, Glenn (1993) The Economics of Rotating Savings
and Credit Associations, American Economic Review

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Credit market in developing economies

& the Micro-nance revolution ?

Karine Marazyan - URN LASTA

February 20, 2024

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 1 / 71

Why do we observe (locally) high interest rates ?

Why do we observe credit rationing ?

Economics of group lending

Beyond group lending ?

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 2 / 71

Why do we observe (locally) high interest rates ?

Why do we observe credit rationing ?

Economics of group lending

Beyond group lending ?

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 3 / 71

See Ted Talks

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 4 / 71

Why do we observe (locally) high interest rates ?

Why do we observe credit rationing ?

Economics of group lending

Beyond group lending ?

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 5 / 71

I Why do we observe (locally) high interest-rates ?

I Why do we observe credit rationing ?

I Why do group-lending work ?

I Beyond group lending

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 6 / 71

Why do we observe (locally) high interest rates ?

Why do we observe credit rationing ?

Economics of group lending

Beyond group lending ?

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 7 / 71

Potential explanations (1)

I Empirically : not supported (at best, local monopoly)

I Interventions consisting in increasing competition did not led necessarily to a

decrease of interest rates

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 8 / 71

Potential explanations (1)

I Empirically : not supported (at best, local monopoly)

I Interventions consisting in increasing competition did not led necessarily to a

decrease of interest rates

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 8 / 71

Potential explanations (1)

I Empirically : not supported (at best, local monopoly)

I Interventions consisting in increasing competition did not led necessarily to a

decrease of interest rates

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 8 / 71

Potential explanations (1)

I Empirically : not supported (at best, local monopoly)

I Interventions consisting in increasing competition did not led necessarily to a

decrease of interest rates

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 8 / 71

Potential explanations (2)

I To adjust the risk of default ?

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 9 / 71

Why do we observe (locally) high interest rates ?

Why do we observe credit rationing ?

Economics of group lending

Beyond group lending ?

Karine Marazyan - URN LASTA Micro-économie du développement February 20, 2024 10 / 71

To manage the risk of default of borrowers

I On capital and/or interest

I Strategic default (in contexts with weak legal systems)

& the Micro-nance revolution ?

I Empirically : not supported (at best, local monopoly)

I Empirically : not supported (at best, local monopoly)

I Empirically : not supported (at best, local monopoly)

I Empirically : not supported (at best, local monopoly)

I Expected prot of k : p(1 + i)L − (1 + r)L

Question : how is i xed ?

I The market is competitive = many moneylenders => expected prot in

I The market is competitive = many moneylenders => expected prot in

I The market is competitive = many moneylenders => expected prot in

I refers to a situation in which, at the going rate of interest in the credit

I To manage borrowers' risk of moral hazard on eort

I Individuals seek to maximize prots

I Moneylenders/banks : competition <=> prot (return of x$ lent - cost of