Credit

Question 1

Uses of credit?

Answer 1

To finance investments:

• in fixed capital: machines, factories…
• working capital
• human capital (tuition fees…)
• to smooth consumption

ALSO allocates funds more efficiently!

• available funds are used where the marginal return is highest
• key to the poor; lack of savings to weather shocks as they depend on seasonal activities (agriculture)
• empirical literature shows strong positive effect of credit on development

Question 2

1:

3 anomalies of credit markets.

Answer 2

Anomaly 1: formal lenders (banks) only lend to the rich

Question 3

Anomaly 2:

Answer 3

credit is rationed (demand is bigger than supply, observed interest rate is lower than i* ) or efficient rate of interest

Question 4

Anomaly 3

Answer 4

informal lenders exists, and lend to the poor instead of formal ones

Question 5

Information asymmetries? What can the lender not observe?

Answer 5

• the choice of project
• the type of the borrower
• the outcome; if the money is actually used to finance the mentioned project

Question 6

Limited liability?

Answer 6

the borrowers are only responsible up to the amount of the collateral (guarantee)
- if the returns to a project are 0, and collateral was 0, the borrower repays 0

Question 7

What two problems occur then?

Answer 7

1. Involuntary default

2. Voluntary default

Question 8

Only way to solve information asymmetries?

Answer 8

A collateral!

For voluntary default, we had

• Honest: 120-110=10
• Dishonest: caught with probability 0.6, so profit for the borrower =
  
  0. 4100+0.6(-110)=-26
• And maybe 0.4(100-110)+0.6(-110)=-70
• Now the borrower prefers to be honest
• The lender lends money

Question 9

Anomaly 3: how do the informal lenders manage to lend to poor people?

Answer 9

Because of:
- repeated interactions, promise of future loans is an incentive to repay this one
- better knowledge of entrepreneurs (more information on risk)
- easier to accept exotic forms of collateral
- cohesive communities:
easier to acquire information
easier to enforce sanctions
- reputation

Therefore, information asymmetries are less severe for informal lenders.

Question 10

How to solve voluntary/involuntary default?

Answer 10

Involuntary default: acquire better information on risks, select the “good” projects

Voluntary default: give incentives to be honest (promise of future loans)

Question 11

Involuntary default is also known as …?

Answer 11

Adverse selection.

• Attract bad risks
• analogy with insurance: if you offer insurance, only the people with bad health will be attracted

Question 12

Voluntary default also known as …?

Answer 12

Ex-ante moral hazard

The mere fact of offering a loan changes the behaviour of people, makes us more reckless.

Question 13

Ex-post moral hazard?

Answer 13

Incentive to lie after the outcome has already happened! Credit markets: after the project succeeded, incentive to say it failed.

Question 14

General about microfinance:

Answer 14

• local organisation to reduce information asymmetries
• group loans (better information and stronger sanctions)
• small loans, no collateral but groups of 5
• convert social capital into a collateral
• given to women:
  more responsible, better repayment, increases education, health…