econ 355w - a. karaivanov lecture notes financial markets ...akaraiva/fin. markets slides.pdf ·...

Econ 355W - A. Karaivanov Lecture Notes

Financial markets in developing countries (rough notes, use only asguidance; more details provided in lecture)

The role of the financial system

• matching savers and investors (otherwise each person needs to saveup by themselves)

• providing payment services (instead of carrying cash)

• generating and distributing information — reflected in stock, bondprices, etc.

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• allocation of credit/capital in the economy (to the uses that yieldgreatest returns)

• pricing, pooling and trading risk (through the insurance market, partof the financial system)

• providing asset liquidity (some investments are long-lived; but can bemade liquid through the stock market, etc.)

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Credit markets

• matching skills with resources

• if financial markets are efficient (perfect information, perfectenforcement) then resources flow to highest returns (highest skills)

• otherwise, economic outcomes depend on how much wealth people startwith, not their talents

• thus, financial markets are important for efficiency, for the economy toreach its potential

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• Why are financial markets particularly likely to be imperfect in developingcountries?

• Buying something vs. paying are often separated over time

• Presence of ‘transaction costs’ — when the time to pay comes people canbe:

— unable to repay (information needed in advance to prevent this; thisis costly)

— unwilling to repay (enforcement needed ex-post to prevent this; thisis costly)

— evidence from India: in 1997, 3.2 outstanding debt cases; 40% formore than 8 years

— also, limited liability — in today’s world there are legal limits onpunishment for reneging on contracts (not true in the past or in blackmarkets)

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Lenders anticipate these issues, so they:

• screen borrowers (if asymmetric information problem in borrower’sriskiness/type)

• monitor borrowers (if asymmetric info in borrower’s effort — if cannotobserve it)

• threaten to cut off from future loans (to help with enforcement problems)

• require collateral (to help with enforcement problems)

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FACTS

• high interest rates in LDCs (Banerjee, 2004) — 52% in rural areas inIndia; 28-62% in urban; in the US — 6-14% 1980-2000

— cannot be explained by default alone (explains at most 23% of theinterest rate level)

— cannot be explained by monopoly power alone — why kill the demandso much? also, public banks and competition from informal sectorpresent

• presence of large informal sector, including moneylenders (provides 20-30% of all loans)

• personalized interest rates (co-existence of various rates, e.g. 12% vs.60% without arbitrage)

• loan amount often restricted by borrower’s wealth/assets — no more loanspossible, no matter what the interest rate — “credit rationing”

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• some people not given a loan of any amount and at any offered interestrate (not consistent with standard supply and demand theory underperfect markets)

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• Evidence for transaction costs:

— the case of Debt Recovery Tribunals in India (Visaria, 2007)— sped up resolution of civil cases about unpaid loans;— reduced loan delinquency by 6-11 percentage points— interest rates fell by 1-2 percentage points

• Cross-country evidence (Djankov et al. 2006)

— study 129 countries over 25 years— finds that lenders’ legal rights (ability to enforce repayment; sell thecollateral) is positively correlated with the private debt to GDP ratio

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• Financial development and growth (Rajan and Zingales, 1998)

— across countries the size of domestic credit market positively correlatedwith GDP per capita

— however, causality can run the other way around — richer countriesmay have larger market for credit

— or, both can be caused by third factors (institutions, good governmentpolicies)

— however, they also find a strong positive evidence on financialdevelopment on growth of industries that are more credit-dependent.

• King and Levine (1993) — find positive correlation between higher initiallevels of financial development and subsequent growth (controlling formany country and policy characteristics)

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THEORY

Three major problems causing financial market imperfections

1. Limited enforcement — borrowers can default even if able to pay

2. Moral hazard — unobserved effort by borrowers affect the probability ofsuccessful investment, hence repayment

3. Adverse selection — unobserved characteristics by borrowers (e.g.,riskiness) affect probability of repayment

• the reason for the market imperfections/failure is either contractenforcement problem (1.) or asymmetric information between lendersand borrowers (2. and 3.)

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Limited Enforcement Example

• suppose the borrower can choose not to repay since probability of gettingcaught (loan enforced) is π < 1 — limited enforcement

• penalty if default and caught is F ; interest rate r, e.g. 20% (i.e. for $1borrowed must return $(1 + r), e.g. $1.20)

• investment of I needed to set up production; borrower has initial wealthA < I

• borrower borrows I −A

• output is q (if investment made)

• the borrower will not default if:

q − (1 + r)(I −A) > q − πF (1)

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• the above inequality says that the income if not default (left hand side)should be larger than the expected income if default (escape with themoney) — the right hand side

• from (1), we obtain that default will not happen as long as:

A > I − πF

1 + r(2)

• thus, only people with high enough wealth will be lent to (the lender willnot lend to someone they know will default; think of F as jail time, etc.not something that the lender gets).

• note how the limited enforcement problem creates credit rationing andinefficiency! — some poor people will not obtain loans, even if theirbusiness projects are profitable (say q > (1 + r)I)

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• the minimum wealth necessary to borrow depends on πF — the highr thefine or the probability of repayment — the more people will be able toborrow. On the other hand, the higher I (i.e., the loan required) or theinterest rate, the higher the wealth threshold.

• Note if the right hand side in (2) is negative then any person can borrow.

• refusing future loans or interlinking can alleviate the above problems

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Moral Hazard Example

• suppose output from a business can be either high (success), yH = 2 orlow (failure), yL = 0

• the probability of success is a function of borrower’s ‘effort’, e; assumefor simplicity prob(yH) = e and prob(yL) = 1− e.

• putting effort is costly, cost 12e2

• investment I = 1 required to run business; opportunity cost of funds, ρ

• assume yH > (1 + r)I — i.e. the investment is worth doing (2 > 1 + r)

Case I: self-financed entrepreneur

maxe

e(2)− ρ(1)− 12e2

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take the derivative and set to zero to find the optimal effort level: e∗ = 2

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Case II: borrowing when effort is observable (no incentive/moralhazard problems)

• the efficient effort level e∗ will be achieved if it is possible to monitoreffort.

• assume the lender is only paid in case of success (the borrower hasnothing otherwise)

• The lender’s expected profit is: ΠL = eI(1 + r)− ρI = e(1 + r)− ρ

• the borrower’s expected profit is ΠB = e(yH − (1 + r)I) − 12e2 =

e(1− r)− 12e2

• if effort is monitorable, the two parties will choose e in the the optimalway to maximize joint profits: Π = ΠL + ΠB = 2e − ρ − 1

2e2 which is

exactly the same expression as that of the self-financed entrepreneur.

• the same, first-best effort level, e∗ is obtained as a result.

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Case III: moral hazard due to unobservable effort

• suppose now the lender cannot observe the effort the borrower puts in

• the borrower knows that when output is low he will pay nothing, whilewhen output is high he must pay the interest;

• it’s as if the borrower’s success is ‘taxed’ — reduces his incentive to putin effort (a ‘moral hazard’ problem occurs)

• The borrower chooses effort alone (to maximize his own income):

maxe

e(yH)− e(1 + r)I − (1− e)(0)− 12e2 = 2e− e(1 + r)− 1

2e2

• take the derivative and set to zero:

2− (1 + r)− e = 0

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or, eMH = 1 + r which is less than e∗ (see above)

• the moral hazard problem leads to lower effort, and inefficiency (higherdefault rates than in the first best; lower expected output).

• possible role for collateral: a collateral requirement (making theborrower lose something in the low output case) will alleviate the moralhazard problem by increasing incentives to work hard

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Adverse Selection Example

• suppose there are two types of borrowers in the population with differentprobability of success of their business projects

• projects either succeed (positive output) or fail (zero output)

— ‘risky’ borrowers have prob. of success 1/2 in which case they getreturn of 4

— ‘safe’ borrowers have prob. of success 1 in which case they get returnof 2

— note, the expected return is the same (2) in both cases but the riskytypes have uncertain (variable return, 4 or 0) vs. the sure return fromthe safe types.

• both types need a loan of size L = 1 to start up their investment project

• risky borrowers default (can’t pay anything) if their project fails

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• suppose the lender does not know the borrower’s type (‘asymmetricinformation’, since borrowers know their type)

• If they knew — easy what to do — just charge different interest rates toboth types (higher for the risky ones)

• However, with unobserved type this is impossible — the same interestmust be charged since unable to tell who is who

• a given loan interest rate may attract very different pools of borrowersdepending how high it is

— if the interest rate set by the lender is low, both types will apply for aloan

— however, setting a high interest rate will only attract the risky types(since they only pay back when their project succeeds)

— note, the risky type expected income is (1/2)(4)+(1/2)(0)−(1/2)(1+r)L = 2− (1/2)(1 + r) so they will borrow up to an interest rate of

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r = 3 (this is the maximum r at which they get at least zero expectedincome)

— for safe types, their expected income is 2− (1+ r)L = 1− r so they’llonly borrow if r ≤ 1.

• This is called ‘adverse selection’ problem — the level of the interest rateset determines the pool of borrowers a lender faces

• setting higher price (interest rate) instead of yielding higher profits (likein a conventional market) may result in facing increasingly more riskyborrowers and actually decrease profits.

• Thus, an (inefficient) equilibrium may result in there is excess demandfor loans (credit rationing again) — but lenders don’t raise the price (theinterest rate) as this may reduce their profits due to the adverse selectioneffect.

• other examples of adverse selection — in insurance markets — plans withvery small deductibles likely to attract very risky clients

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• role for collateral again: if the lender offers two contracts: one with lowr but high collateral and one with high r but low collateral — borrowerswill self-select into them (safe will pick low r, risky will pick high r) —can show this can restore efficiency (obtained in the benchmark with noasymmetric information)

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APPLICATIONS/POLICY

• the above theoretical considerations explain the relative success of certaininnovative credit mechanisms in developing countries such as microcredit

ROSCAs (rotating credit and savings associations)

• — in the presence of credit market impeftections (credit rationing) oftenformed in LDCs to facilitate buying expensive households asset (e.g.TV, washer) or business assets (e.g. motorbike)

— group of people make monthly contributions and one (often randomly)chosen to take the pot each month

— on average, everyone but the last person to win the pot buys the assetsooner — efficiency improvement

— issues: enforcement, how to ensure people keep contributing afterwinning; group size/composition matters

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Microfinance institutions (MFI)

• microfinance: supply of credit, saving vehicles and insurance to poorpeople who are otherwise outside the formal financial sector (rationedout)

• original idea (Mohammad Yunus’ Grameen Bank in Bangladesh) — grouplending

— a group of borrowers responsible for a loan to one of its members— meaning that if a group member does not pay — all others areresponsible for their loan; can be cut off from future credit

— typically, no collateral required— very high repayment rates reported

• Why does it work? several reasons, related to the theory discussionabove.

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• Moral hazard — reduced since the group members can monitor each other(the bank effectively delegates these costs to the borrowers)

• Adverse selection — reduced since the group members know each otherand would form groups with people like them

• Enforcement problems — reduced since group members can exercise peerpressure to ensure repayment

• Basically, instead of physical asset collateral, the group’s superiorinformation, monitoring and enforcement serves as ‘social collateral’that the lender can exploit to provide credit to poor people who wouldotherwise be rationed out by traditional, individual liability lenders suchas commercial banks

• Other ‘innovations’ used by MFI

— dynamic incentives — at first small loans are given and new, larger

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loans provided only if previous loans are paid (same as what creditcard companies here do)

— flexible collateral — accept items that are valuable to the borrower (e.g.wedding ring; working animals) even if not so valuable to the lender

— targeting women borrowers — higher repayment rates achieved. Why?possible explanations are that women are more risk-averse (psychology)and that they have fewer outside options (lower incentives to default,‘nowhere to go’)

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MFI and subsidies

• historically MFI have been subsidized by NGOs or governments

• should we keep subsidizing or require that MFIs start breaking even?

• are MFI a tool for re-distribution (to target the poorest potentialmicroentrepreneurs) or filling in a profitable niche in the financial market?

• possible idea: tie microcredit to social services that are demanded onlyby the poor and are costly to participate in (act as screening mechanismto find out who really needs the money

• for more discusison see the case studies after ch. 5 and ch. 11 in thebook

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econ 355w - a. karaivanov lecture notes financial markets ...akaraiva/fin. markets slides.pdf ·...

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