Credit Markets: Basic Problems and Past Policies October 2008 () - PowerPoint PPT Presentation

Credit Markets: Basic Problems and Past Policies October 2008 () Credit Market Problems October 2008 1 / 13

Basic Problems (circa 1950): Low quantity of domestic savings — major constraint on investment, especially in manufacturing () Credit Market Problems October 2008 2 / 13

Basic Problems (circa 1950): Low quantity of domestic savings — major constraint on investment, especially in manufacturing Dualistic credit market () Credit Market Problems October 2008 2 / 13

Basic Problems (circa 1950): Low quantity of domestic savings — major constraint on investment, especially in manufacturing Dualistic credit market → formal sector — commercial and government run banks serving ֒ urban sector and large landowners () Credit Market Problems October 2008 2 / 13

Basic Problems (circa 1950): Low quantity of domestic savings — major constraint on investment, especially in manufacturing Dualistic credit market → formal sector — commercial and government run banks serving ֒ urban sector and large landowners → informal sector — small scale lenders and agricultural cooperatives ֒ serving small scale rural borrowers and the informal urban sector () Credit Market Problems October 2008 2 / 13

Basic Problems (circa 1950): Low quantity of domestic savings — major constraint on investment, especially in manufacturing Dualistic credit market → formal sector — commercial and government run banks serving ֒ urban sector and large landowners → informal sector — small scale lenders and agricultural cooperatives ֒ serving small scale rural borrowers and the informal urban sector Skewed distribution of credit access — a source of persistent and widening wealth disparity. () Credit Market Problems October 2008 2 / 13

The Development Planning View Dominant paradigm (1960s / 70s) Monopolistic moneylenders, especially in rural areas () Credit Market Problems October 2008 3 / 13

The Development Planning View Dominant paradigm (1960s / 70s) Monopolistic moneylenders, especially in rural areas Lack of “financial depth” () Credit Market Problems October 2008 3 / 13

The Development Planning View Dominant paradigm (1960s / 70s) Monopolistic moneylenders, especially in rural areas Lack of “financial depth” → low savings due to uncertainty regarding potential bank failure and ֒ ineffective legal systems () Credit Market Problems October 2008 3 / 13

The Development Planning View Dominant paradigm (1960s / 70s) Monopolistic moneylenders, especially in rural areas Lack of “financial depth” → low savings due to uncertainty regarding potential bank failure and ֒ ineffective legal systems → lack of alternatives financial assets catering to varying needs of ֒ potential savers/lenders. () Credit Market Problems October 2008 3 / 13

Interest Rate D(r) MC r AC M r MR L Loans M Figure: Monopoly Lender () Credit Market Problems October 2008 4 / 13

Policy Strategy: “put the moneylender in his place” () Credit Market Problems October 2008 5 / 13

Policy Strategy: “put the moneylender in his place” → development banks to lend at low rates to rural borrowers ֒ () Credit Market Problems October 2008 5 / 13

Policy Strategy: “put the moneylender in his place” → development banks to lend at low rates to rural borrowers ֒ initially fill savings gap with tax revenue and foreign loans/aid () Credit Market Problems October 2008 5 / 13

Policy Strategy: “put the moneylender in his place” → development banks to lend at low rates to rural borrowers ֒ initially fill savings gap with tax revenue and foreign loans/aid Eventually banks would become self–financing () Credit Market Problems October 2008 5 / 13

Policy Strategy: “put the moneylender in his place” → development banks to lend at low rates to rural borrowers ֒ initially fill savings gap with tax revenue and foreign loans/aid Eventually banks would become self–financing BUT () Credit Market Problems October 2008 5 / 13

Policy Strategy: “put the moneylender in his place” → development banks to lend at low rates to rural borrowers ֒ initially fill savings gap with tax revenue and foreign loans/aid Eventually banks would become self–financing BUT → failed to drive out informal moneylenders ֒ () Credit Market Problems October 2008 5 / 13

Policy Strategy: “put the moneylender in his place” → development banks to lend at low rates to rural borrowers ֒ initially fill savings gap with tax revenue and foreign loans/aid Eventually banks would become self–financing BUT → failed to drive out informal moneylenders ֒ → development banks did not become financially viable ֒ () Credit Market Problems October 2008 5 / 13

Policy Strategy: “put the moneylender in his place” → development banks to lend at low rates to rural borrowers ֒ initially fill savings gap with tax revenue and foreign loans/aid Eventually banks would become self–financing BUT → failed to drive out informal moneylenders ֒ → development banks did not become financially viable ֒ → access to formal credit remained skewed towards large landowners ֒ () Credit Market Problems October 2008 5 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to () Credit Market Problems October 2008 6 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to → seasonal activity ֒ () Credit Market Problems October 2008 6 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to → seasonal activity ֒ → systemic risk ֒ () Credit Market Problems October 2008 6 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to → seasonal activity ֒ → systemic risk ֒ → geographically dispersed customers ֒ () Credit Market Problems October 2008 6 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to → seasonal activity ֒ → systemic risk ֒ → geographically dispersed customers ֒ → absence of collateral — land is often untitled ֒ () Credit Market Problems October 2008 6 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to → seasonal activity ֒ → systemic risk ֒ → geographically dispersed customers ֒ → absence of collateral — land is often untitled ֒ → difficulty of enforcing repayment ֒ () Credit Market Problems October 2008 6 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to → seasonal activity ֒ → systemic risk ֒ → geographically dispersed customers ֒ → absence of collateral — land is often untitled ֒ → difficulty of enforcing repayment ֒ ⇒ lack of information reflects acquisition costs () Credit Market Problems October 2008 6 / 13

The Chicago School View Informal sector is competitive, but risky and costly due to → seasonal activity ֒ → systemic risk ֒ → geographically dispersed customers ֒ → absence of collateral — land is often untitled ֒ → difficulty of enforcing repayment ֒ ⇒ lack of information reflects acquisition costs ⇒ high interest rates reflect risk not monopoly power () Credit Market Problems October 2008 6 / 13

Lender’s risk hypothesis: Profit per $ loaned = p ( 1 + r ) − ( 1 + i ) where = r lending rate = marginal cost of funds i = p probability of repayment () Credit Market Problems October 2008 7 / 13

Lender’s risk hypothesis: Profit per $ loaned = p ( 1 + r ) − ( 1 + i ) where = r lending rate = marginal cost of funds i = p probability of repayment → Competition ⇒ zero economic profits ֒ () Credit Market Problems October 2008 7 / 13

Lender’s risk hypothesis: Profit per $ loaned = p ( 1 + r ) − ( 1 + i ) where = r lending rate = marginal cost of funds i = p probability of repayment → Competition ⇒ zero economic profits ֒ → risk–adjusted interest rate ֒ r = 1 + i − 1 p () Credit Market Problems October 2008 7 / 13

Interest S(r) Rate r d r * r I(r) Savings, S(r d ) Investment S(r) I* Figure: Implications of Interest Rate Ceiling () Credit Market Problems October 2008 8 / 13

Policy implication: government intervention is bound to fail () Credit Market Problems October 2008 9 / 13

Policy implication: government intervention is bound to fail → removal of interest rate ceilings ֒ () Credit Market Problems October 2008 9 / 13

Policy implication: government intervention is bound to fail → removal of interest rate ceilings ֒ → credit market liberalization pushed by external lenders ֒ () Credit Market Problems October 2008 9 / 13

Policy implication: government intervention is bound to fail → removal of interest rate ceilings ֒ → credit market liberalization pushed by external lenders ֒ BUT () Credit Market Problems October 2008 9 / 13

Policy implication: government intervention is bound to fail → removal of interest rate ceilings ֒ → credit market liberalization pushed by external lenders ֒ BUT → localized information limits competition ֒ () Credit Market Problems October 2008 9 / 13