EC319 Development Economics

Lecture 7: Topic 5
Credit markets: market failures

Dr. Samantha Rawlings

s.b.rawlings@reading.ac.uk
Edith Morley 190

Copyright University of Reading

This lecture will discuss:

1. The importance of finance for development

2. Barriers to lending to the poor in developing countries.
3. Market failures in credit markets.
Quick questions:

Do you have a bank account? Have you ever had a credit card,
bought something on credit (“buy now,
a) Yes pay later”/Klarna/Paypal pay in 3), or
taken out a loan?
b) No

a) Yes
b) No
Access to financial services
source: Our World in Data https://ourworldindata.org/grapher/account-at-financial-institution
Source: Demirguc-
Kunt, A., Klapper, L.,
Singer, D., Ansar, S., &
Hess, J. (2018). The
Global Findex
Database 2017:
measuring financial
inclusion and the
Fintech revolution. The
World Bank.
Question:

Why is finance important for development?

 Why is finance important for development?

• Allocate funds and risk productively and efficiently.

• Boosts economic growth.
• Improves opportunity.
• Redistribute income.
• Reduces poverty.
Lack of finance is a barrier to development

• Imperfections or failures in the financial market can be cause for

persistent income inequality or ‘poverty traps’.
• Market failures force individuals to rely on personal wealth.

• Imperfections such as information asymmetries and transaction

costs likely to particularly affect the poor.

Result: the poor are more likely to be excluded from financial

markets
Borrowing: richest 60% vs poorest 40%
source: Our World in Data https://ourworldindata.org/grapher/loan-from-a-financial-institution-poorest-40-vs-richest-60
Credit Market Failures
Financial market imperfections

• informational asymmetries
• transactions costs
• contract enforcement costs

are particularly binding on poor or small entrepreneurs who lack collateral,

credit histories, and connections.
Asymmetric information

A source of market failure that can cause valuable markets to:

1. Disappear
or
2. To be characterized by rationing

• In this context: credit markets may not exist or be inaccessible to the

poor
• Fewer financial services may be offered than those demanded at going
interest rates).
Two types of asymmetric information might
lead to failure in credit markets

1. Adverse selection:, the lender knows less about the

quality of the investment project and investor than the
borrower does.

2. Moral hazard, the lender knows less about the

borrower’s behaviour than the borrower does.
Moral hazard: a hidden action problem

• Arises when effort of borrowers affects success of projects.

• Success of project determines ability to repay.
• Lenders may not be able to observe work effort of borrowers
• “hidden action” = working hard
• Lenders cannot force borrowers to work hard
• Key result we will show:

In credit markets characterised by moral hazard, increases in interest rates

can reduce borrowers’ incentives to work hard, raising their default rates.
Moral Hazard: The model

Terms of borrowing:
• Loan size
• Interest rate %
• Cost to working hard
Key feature of the credit market is limited liability:
• Repays loan + interest when successful (return )
• Repays 0 when unsuccessful (return )
Moral Hazard: The model
• Two potential outcomes:
1. Bad (failure)
2. Good (success)
State of the world: “Bad” “Good”
Works hard R R
Shirks (low effort) 0 R

P(bad) = P(good) = 0.5

• Limited liability means repayment only if successful (Good
state of the world)
Moral Hazard Return

Repay Loan + Interest

• Expected profit when borrows and works hard:

Cost of effort
• Expected profit when borrows and shirks:

Probability of success Repay Loan + Interest

Return
Moral Hazard

• Expected profit when borrows and works hard:

• Expected profit when borrows and shirks:

Question: what determines whether a borrower

works hard?
Will the borrower work hard?

• Whether the borrower works hard depends on:

1. The return to investment
2. The cost (price) of a loan
3. The cost of effort
• We can derive the condition under which a borrower will work hard.
• Since and are fixed in the model, what matters for effort?
• Answer: the interest rate
 Compare profits for working hard vs.
shirking:
𝑷 𝒘 = 𝑹 − 𝑪 − 𝑳(𝟏+𝒓 𝒃) 𝑷 =𝟎 .𝟓 ( 𝑹− 𝑳 𝟏 +𝒓 ) )
(
𝒔 𝒃

Increase in Cost of working

expected profits hard (decrease
derived from in expected
working hard profit)
 Rise in interest rate reduces incentives to
work hard

• Benefit to effort shrinks

• Cost of effort remains constant
• This diminishes the incentive to work hard
• When the interest rate rises high enough, borrower will have no
incentive to work hard.

How high is ‘high enough’?

 At what point does the interest rate go so high
that a borrower won’t put in effort?
Difference between
return R and cost C
Answer: when > 0. This is when:

• Borrower now has no incentive to work hard

• They do still find it profitable to borrow, invest, and shirk. Loan size
• This generates a tendency for increasing default rates as interest rates rise.
• The result?
• Credit rationing
• Missing markets
Summary: Moral Hazard

In credit markets characterized by moral hazard,

increases in interest rates can reduce borrowers
incentives to work hard, raising the default rate.

• When borrowers work hard they repay with interest in most states of the world.
• When borrowers don’t work hard, they repay in only some states of the world.
• So increases in the interest rate are more of a drag on the profitability of borrowing and
working hard than they are on borrowing and shirking.
• And increases in the interest rate may cause borrowers to not work so hard at
preventing bad outcomes.
Adverse Selection

• So far, we have assumed that all borrowers pose the same amount
of risk to the lender.
• In reality, there are high and low risk borrowers.
Asymmetric information:
• Borrowers may have more information about their risk than lenders.
• Will consider the Stiglitz and Weiss (1981) model of credit rationing.
Adverse Selection: A hidden information problem

• Potential borrowers differ in their inherent default probabilities

• Borrowers know their default probabilities but lenders do not
• “hidden information” = default probability
• Lenders cannot distinguish borrower types and must charge identical interest
rates to all borrowers

In credit markets characterised by adverse selection, better risks might

drop out of the market more rapidly than the worse risks as interest
rates rise. As a result, average default rates might rise.
Adverse selection

• P(bad) = P(good) = 0.5

Two borrowers:
• Safe – repays in any state of the world
• Risky – risky investment with significant probability of default
Expected return of two projects is the same = R

State of the world: “Bad” “Good”

Safe borrower R R
Risky borrower R-e R+e
Adverse selection: Assumptions

• Lender can’t distinguish between different types so offers one interest rate .
• Each borrower requires loan .
• Borrowers are honest and will always repay if they can.
• Safe borrower repays in every state of the world, whilst risky only repays in
good state:

Risky return Risky return

in bad state in good state
Loan
Repayment
Adverse selection: Assumptions

• Limited liability- lender cannot force repayment more than fixed

amount P:

• P is less than return in bad state

• Borrowers are risk neutral
• Undertake investment as long as expected profit is positive.
• Expected profit is expected value of return minus loan
repayments.
 Return (certain)
Adverse selection
Repay loan plus interest

Profit in good state

• Safe borrower expected profits: of the world

• Risky borrower expected profits:

Probability of
state occurring

Note that safe borrower’s profits do not depend on state of the world, whilst risky
borrower’s profits do! Profit in bad state of the world
Adverse selection

• Safe borrower expected profits:

• Risky borrower expected profits:

Note that safe borrower’s profits do not depend on state of the world, whilst risky
borrower’s profits do!
Adverse selection

• Maximum interest rate safe borrower willing to pay = and solves :

This implies:

• Maximum interest rate risky borrower willing to pay = and solves:

This implies:
Which is larger? or

𝒓 (𝟐 𝑹 − 𝑷 ) 𝒔 𝑹
𝒓 = −𝟏 𝒓 = −𝟏
𝑳 𝑳

Questions:
1. Which borrower type is willing to borrow at higher interest
rates?
2. Why?
Which is larger? or

𝒓 (𝟐 𝑹 − 𝑷 ) 𝒔 𝑹
𝒓 = −𝟏 𝒓 = −𝟏
𝑳 𝑳

if
• This is true, since
• So risky borrower willing to borrow at higher interest rates.
 Risky borrower willing to borrow at higher
interest rates

• If interest rate , then safe borrower drops out of the

market.
• Why does this matter? Leads to
• Missing markets
• Credit rationing
Summary: adverse selection

• Investors with “good project” expect to repay with interest in most states of
the world.
• Investors with “bad projects” expect to repay with interest in only some states
of the world.
• So increases in the interest rate are more of a drag for investors with good
projects than investors with bad projects.

With adverse selection, an increase in interest rate may cause

the default rate to rise, because it may cause borrowers with
good and safe projects to drop out of the market more rapidly
than borrowers with risky projects.
Credit market failures

If an increase in the interest rate causes the default rate to rise, then:
• increasing the interest rate may fail to increase the lender’s profitability of
lending, so
• the lender may ration loans:
• Offer fewer loans than demanded at current rates
• Rather than raising price (interest rate)
• the market may be missing:
• lender may be unable to find any interest rate at which lending is profitable
Quick recap:

Issues of moral hazard in credit As interest rates increase, less safe

markets are normally reflected in: projects are financed and more risky
projects apply for loans. This is called:
a) borrowers likely choosing a risky project
with the possibility of higher returns over a
safe project with lower returns. a) an efficient market.
b) banks lending to bad borrowers even if the
probability of success for a safe project is b) adverse selection.
high.
c) credit rationing.
c) borrowers always choosing the safe project
even if it implies lower returns. d) moral hazard.
d) high levels of interest rates charged to
similar borrowers.
Question:

What might a lender do to lower their risk of a borrower

defaulting?

[hint: think about mechanisms in loan markets in the UK or

other markets such as housing where there is risk of default]
Lenders use collateral to lower their risk

One approach to mitigate information asymmetry problems is to

require borrowers to post collateral.
• Pledge to relinquish assets to lender in event of default.
• Works to mitigate information asymmetry in two ways:
1. Lenders can recoup costs after default.
2. Borrowers are incentivised to work harder/make prudent choices.
Collateral leads to financial exclusion

• Poor borrowers have few assets to offer as collateral.

• If lending is contingent on such collateral, poor borrowers
with few assets have access to only small loans.
• Potential borrowers with no assets to offer as collateral are
unable to borrow at all in such markets.
Implications of asymmetries

• Rich can repay in all contingencies by dipping into their pockets if a

project goes badly, so banks discriminate in favour of them.
• The way institutional credit agencies discriminate is through
insisting on collateral before making a loan.
The result:
• The rural poor have access to a limited supply of institutional credit
and an excessive reliance on informal sources.
 After this lecture you should:

Next Steps: You should make sure you

understand:
1. Moral hazard
2. Adverse selection.

You should review:

The relevant sections of
Schaffner (particularly Box 10.2)
to ensure you understand the
models presented in class.
Optional: Review the appendix
derivations of the model.
Readings

1. Schaffner, Julie. Development Economics: Theory, Empirical Research and

Policy Analysis. John Wiley and Sons. 2014. Chapters 10.3
 Appendix: Derivations Of Formulas
For Adverse Selection And Moral
Hazard

Please note: you are not expected to reproduce the following in your assignments
but this is provided for your information
Moral hazard: derivations slide #20

Compare profits for working hard vs. shirking:

Moral hazard: derivations slide #22
At what interest rate will the borrower shirk?
Find the answer to this by setting , then rearranging.
Note:
Answer:

How derived:

[multiply by 2 to get rid of the 0.5 in the equation]

[note this is the same as the answer in the slides except there rb is written on the left hand side.]
Adverse Selection: derivation slide #31

Maximum interest rate safe borrower willing to pay = and solves:

This implies:
Derivation:
Adverse selection: Derivation slide #31
Maximum interest rate risky borrower willing to pay = and solves:

This implies:
Derivation:

[multiply by 2 to get rid of the 0.5]

Adverse selection: Derivation slide #32

Which is larger?
if
This is true, since
if:

These are the same except the numerator. So if

So risky borrower willing to borrow at higher interest rates.

If interest rate , then safe borrower drops out of the market.