Manual The Economics of Microfinance (MIT Press)

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The Economics of Microfinance, Second Edition, vol 1

Microeconomics For Dummies - UK. Peter Antonioni. Thomas Nechyba. Intermediate Microeconomics. Hal R. The Economics Anti-Textbook. Rod Hill. The Economics of Social Problems. Sheila Smith. Microeconomics: A Very Short Introduction. Avinash K. Walter Nicholson. Workouts in Intermediate Microeconomics. The Power to Compete. Hiroshi Mikitani. The Enlightened Economy. Joel Mokyr. Reinventing the Bazaar. John McMillan. Microeconomic Theory. Christopher Snyder.

The Economics of Microfinance, vol 1

Economics of Strategy. Microfinance and Amartya Sen's Capability Approach. Chuan Chia Tseng - unknown. An Exploratory Study. Marion Allet - - Journal of Business Ethics 3 Potentiality of Women Unveiled: Microfinance Erin Bass - - Journal of Business Ethics 4 Applying Economics, Using Evidence. Roger E. The Paradox of Popularity in Economics. Diane Coyle - - Journal of Economic Methodology 19 3 Added to PP index Total views 24 , of 2,, Recent downloads 6 months 4 , of 2,, How can I increase my downloads?

Sign in to use this feature. But, according to the rules, if one member defaults and fellow group members do not pay off the debt, all in the group are denied subsequent loans. Repayments are made in public, that is, before the forty members of the center, in weekly installments. Group lending thus takes advantage of local information, peer support, and, if needed, peer pressure.

The program thus combines the scale advantages of a standard bank with mechanisms long used in traditional modes of informal finance. In addition, the bank uses an unusual repayment schedule: Repayments usually begin just a week after the initial loan disbursal and continue weekly after that; this makes the contract look much closer to a consumer loan than a business loan and changes the nature of the risk that the bank is taking on—and the service that it is pro- viding.

Beyond these economic mechanisms, Grameen has found that not only does having a customer base that is 95 percent female improve social impacts, but it may also reduce the financial risk for the bank, an issue to which we return in chapters 5 and 7. Disentangling how the various mechanisms work matters, since what works in Bangladesh may work less well in Brazil or Uganda.

Even in rural Bangladesh a variety of approaches are being employed. ASA, for example, started with group lending in , with twenty- person groups rather than five-person groups and a highly stan- dardized process. We unpack these mecha- nisms and models in chapters 4 and 5. The small difference in language signals, for some, a big dif- ference in opinion.

The focus was explicitly on poverty reduction and social change, and the key players were NGOs. The push to embrace savings is a welcome one, because it recognizes the pent-up demand for secure places to save, and in that context, the shift from microcredit to microfinance should not be contentious. Debate arises, though, with the relatively new and wrongheaded in our belief argument that in fact the poorest customers need savings facilities only—that making loans to the poorest is a bad bet.

In the process it also brings out tensions that run through academic work on household consumption patterns in rural areas.

UCL facilities

Those who see informal moneylenders as exploitative are sensitive to the power- lessness of poor borrowers e. But, as Basu argues, the question then becomes: Why do the poor remain powerless? If only borrowers could tuck away a bit of money at regular intervals, eventually they would accumulate enough to get out from under the clutches of the moneylender. Against this is the argument that, to the contrary, even the very poor can save in quantity if only given the chance. Moreover, Adams and von Pischke argue that very poor households can seldom produc- tively use loans.

Exactly counter to Bhaduri, they argue that savings facilities and not loans are thus critical for the poorest. In chapter 6, we attempt to steer between these two poles of rheto- ric. Our view is that the very poor can profit from having better ways to both save and borrow—although the belief, for now, rests more on inference than on direct evidence. These problems are magnified in rural areas where the majority of the poor live because of the high incidence of aggregate risk from floods, droughts, and infectious disease.

This makes common types of losses particularly difficult to insure against through local measures, and the problems leave most poor households lagging far behind more afflu- ent individuals. But in chapter 6 we describe several innovations in insurance provision that attempt to match the successes of micro- finance to date. Microfinance presents itself as a new market-based strategy for poverty reduction, free of the heavy subsidies that brought down large state banks.

The international Microcredit Summit held in and its follow-up in have been graced by heads of state and royalty, and Bill Clinton, former president of the United States, made numerous official visits to microfinance programs while traveling overseas. As foreign aid budgets have been slashed, microfi- nance so far remains a relatively protected initiative.

Somewhat paradoxically, though, the movement continues to be driven by hundreds of millions of dollars of subsidies, and those sub- sidies beget many questions. The hope for many is that microfinance programs will use the subsidies in their early start-up phases only, and, as scale economies and experience drive costs down, programs will eventually be able to operate without subsidy. Once free of subsidy, it is argued, the programs can grow without the tether of donor support be it from governments or donors. To do this, sustainability-minded advocates argue that programs will need to mobilize capital by taking savings deposits or by issuing bonds, or institutions must become so profitable that they can obtain funds from commercial sources, com- peting in the marketplace with computer makers, auto manufacturers, and large, established banks.

The three-year bond pays purchasers 2. A second million-peso bond was planned for the end of ACCION is committed to the growth of financially self-sufficient microlenders who need not depend on donor funding to fight poverty. The fact that Compartamos does not suffer from a lack of clients suggests that there are low-income customers in Mexico willing and able to pay high fees.

Microlenders elsewhere, though, have balked at charging high rates; in Bangladesh and Indonesia the main institutions keep interest rates below 50 percent per year, and typically around 30 percent in economies with inflation at about 10 percent. Why balk at high rates? Let us return to the principle of diminishing marginal returns to capital.

Can all poorer borrowers really pay higher interest rates than richer households? An unspoken assumption made in figure 1. If this is untrue and it is hard to imagine it would be true , it is easy to see that entrepreneurs with less capital could have lower marginal returns than richer households. We illustrate this point in figure 1. Poorer entrepreneurs have lower marginal returns despite having less capital.

Some might, of course, but a considerable group would plausibly be screened out by high rates. Figure 1. Here, there may be larger profits per dollar invested by the larger-scale entrepreneur rela- tive to the returns generated by the entrepreneur with less capital. Here, again, poorer households cannot pay for credit at high prices.

This case has the feature that, without adequate financing, poorer entrepreneurs may never be able to achieve the required scale to compete with better-endowed entrepreneurs, yielding a credit-related poverty trap. As in figure 1. The Grameen Bank, for example, still takes advantages of subsidies twenty- five years after its start. A different question is whether the anti-subsidy position is the right one—or, more precisely, whether it is the right position for all programs. Again, there is a parallel with trade theory. The strongly anti-protectionist sentiments that had characterized trade theory for decades Bhagwati are now giving way to more nuanced approaches to globalization, with mainstream economists identifying cases that justify extended protection in the name of economic and social development e.

So, too, with microfinance: Serious arguments are accumulating that suggest a role for ongoing subsidies if thoughtfully deployed. In Shafiqual Choudhury started ASA as a small grassroots organization to provide legal aid and train- ing in villages, with the hope of raising the social consciousness of rural households. But in , Choudhury and ASA took a very different turn. Instead of placing hope in consciousness-raising, the leaders of ASA decided that the way to most quickly raise the well-being of the rural poor was by providing banking services, and banking services only.

But other institutions started where ASA did and took a broader approach to microfinance. They can also count successes, but their bottom lines include improvements in health and education outcomes in addition to financial metrics. Pro Mujer adds education ses- sions on health topics to weekly bank meetings for customers. If you are in Dhaka these days, for example, you can buy Aarong brand chocolate milk, which is produced by a BRAC dairy marketing affiliate.

A different BRAC subsidiary produces Aarong brand textiles made by poor weavers, and still another sub- sidiary runs craft shops that sell the goods of microfinance clients. The microfinance movement is thus populated by diverse institu- tions, some large and many small, some urban and some rural, some more focused on social change and others more focused on financial development. If the programs that are focusing on social change are cost-effectively achieving their goals, should we be concerned that part of their operation is subsidized?

We focus on one important strand of these entangled assumptions in chapter 9. The debate continues as to whether this is pos- sible and, if so, even desirable. Introducing a stronger economic frame will sharpen understandings, and in chapter 9 we analyze concepts behind the trade-offs between lending practices that maximize the depth of outreach i. The book closes by turning to a critical practical issue for microlenders: how to give staff members the appro- priate incentives to carry out their economic and social missions. In chapter 10 we draw lessons from agency theory and behavioral eco- nomics to describe and challenge conventional wisdom on good man- agement practices.

As described in greater detail in chapter 2, the problems largely hinge on market failures that stem from poor information, high transactions costs, and difficulties enforcing contracts. Microfinance presents itself as an answer to these problems. It chal- lenges long-held assumptions about what poor households can and cannot achieve and, more broadly, shows the potential for innovative contracts and institutions to improve conditions in low-income com- munities. They too may have a role. Can poverty be most effectively reduced by providing financial services alone?

Bold visions have taken the movement this far, and strong, clear ideas are needed to carry the movement forward. Reaching million people as practitioners hope to do by the time this book is first pub- lished is impressive, but as the leaders of the movement are quick to point out, this is just a minority of those who lack access to efficient and reliable financial services at affordable interest rates. In the next chapters we set out ideas that will help evaluate experiences to date, frame debates, and point to new directions and challenges.

Microfinance has grown most quickly in low-income countries, but many poorer households in richer countries also lack access to high- quality financial services at reasonable prices. Why would opportuni- ties and constraints for microfinance differ between richer countries and poorer countries?

Consider an investor in Hong Kong trying to decide how to allocate her investment portfolio. Why might investing in Kenya or Bolivia seem riskier than investing closer to home? Why might it seem riskier than investing in the United States or Europe? Are there parallels to the investment problem of a bank considering whom to lend to within a given country? How does the marginal return to capital help determine the maximum interest rate that a microlender can charge its customers? Rethinking Banking 23 4. Suppose that a household derives income from a business whose only input is capital.

Show that the marginal return to capital is decreasing in K. Is the mar- ginal return to capital still decreasing in this case? Construct a numer- ical example to illustrate your answer. Consider the following investment projects. A project could take place in Russia, where the probability of political turmoil in the district in question is one-half.

If there is no political turmoil, an entrepreneur obtains a return of euros. If political turmoil does take place, the entrepreneur does not get anything. Another project could take place in Belgium, where the same entrepreneur may obtain a return of euros with certainty. Suppose that the same number of euros is required to obtain a positive return from a project in either country. Assume that the entrepreneur is considering investing in a project in either Russia or Belgium. And suppose that the entrepreneur only wishes to maxi- mize expected profit i. In which country would you predict that she will invest?

Briefly explain your answer. A bank is being subsidized by the government in the following way: Each time the bank extends a 1,peso loan, it gets a subsidy of pesos. There are two potential borrowers to which the manager of the bank can extend a subsidized loan. A borrower of type A promises to repay 50 percent of her profit on the 1,peso loan. A borrower of type B promises to repay 10 percent of her profit.

The Economics of Microfinance (The MIT Press)

Which of the borrowers will the manager choose to finance if they want to maximize expected profits? In section 1. Why might Compartamos nevertheless create social benefits even at very high interest rates? As highlighted in section 1. Against this background, microfinance emerged as an especially prom- ising way to rethink banking for the poor. Assessing the successes and failures of the early experiences—and, more important, thinking about newer ideas and innovations— requires clear understandings of the aims for intervening.

Policymak- ers and practitioners often skip this beginning step in the hurry to get new programs started. But, as we show, the result is that debates remain unresolved about issues as basic as whether existing credit markets deserve any interventions at all. We believe that appropriately designed interventions can often help, and this chapter describes why. More generally, we aim to clarify principles to use when considering why and when microfinance works—and why and when it fails to achieve its promise.

To help answer the questions, sections 2. When markets fail, hardworking entrepreneurs cannot obtain all of the capital needed to run their businesses. As a result, they may turn to wage labor, stay in traditional farming, or take other paths that are less desirable and less profitable. Paulson and Townsend seek to understand who becomes an entrepreneur and why.

Of the households who would like to change occupations, most would like to open a business. Many of these households report that they do not start businesses because they do not have the necessary funds. Among entrepreneurial house- holds, 54 percent report that their business would be more profitable if they could expand it. When asked why they do not undertake this profitable oppor- tunity, 56 percent of households report that they do not have enough money to do so.

Both the formation of new businesses and the way that existing busi- nesses are run appears to be affected by financial constraints. The costs of those financial constraints are suggested by the finding that the average annual income of business owners in the sample is three times higher than that of non—business owners. Business owners may, of course, also have more relevant skills than non—business owners.

If that is so, the comparison overstates the advantage that an average person would gain by switching from farming to business. But the Thai data set is rich with measures for talent, and Paulson and Townsend find that, even after accounting for entrepreneurial ability, poorer households are less likely to start new businesses. They thus argue that the income difference is not explained away by a talent dif- ference, leaving credit rationing as the chief candidate.

Studies that directly measure financial constraints thus give one impetus for the microfinance movement. Instead, determining whether there is an important niche for microfinance requires under- standing how markets work and how the informal sector fills gaps— and how and where markets and the informal sector come up short. This chapter describes rationales for interevention, common sources of market failure, and some simple possibilities short of microfinance to improve matters.

Section 2.

The Economics of Microfinance by Beatriz Armendariz, Jonathan Morduch | Waterstones

In particular, we describe evidence on moneylenders and what they do. Since an important rationale for microfinance is that it improves on the status quo, we first assess the existing landscape of informal credit. Are mon- eylenders really exploitative? Will squeezing them out make matters better or worse? Why might it seem that microfinance can do better? Why Intervene in Credit Markets? Sections 2. This is the other part of the existing financial landscape, although the scene is notable often for the absence of commercial banking rather than its presence.

In providing the basic analytics of adverse selection section 2. We employ both algebra and numerical examples to make the points, and we return to the same analytical structures in chapter 4 to explain why microfinance can help. The most important is that raising interest rates is not always profitable for banks working in poor communities—and this can impose a major bind on commercial banks trying to expand access.

We show that profitability can be undermined because raising interest rates can exacerbate incentive problems in lending. Without added measures to retain good incentives—such as those provided by microfinance con- tracts—commercial banks will understandably avoid places where col- lateral is scarce and operating costs are high. Before getting to microfinance contracts, sections 2. Looking even further ahead, chapter 3 is devoted to community-level approaches to credit market problems.

Moneylenders are routinely characterized as exploita- tive monopolists who systematically squeeze the poor. The poor, for their part, are seen as vulnerable, driven to pay usurious rates out of desperation. The enmity is long-standing. The New Testament is generally mute on the topic, although canonical laws in the Middle Ages took strong stands against moneylending with an exception made for Jews. Singh , for example, surveys seven moneylenders in a village close to Amrit- sar in the Punjab region of India, finding annualized interest rates from to percent—rates that were far higher than commercial bank interest rates.

In Thailand, Siamwalla et al. Siamwalla et al. In the market town of Chambar in Pakistan, Aleem finds interest rates varying from 18 to percent, with an average of just under 70 percent per year; in contrast, local banks in the region charged 12 percent per year. In present-day low-income communities, moneylenders remain an important part of the financial landscape, with just as much debate about their roles. Moneylenders, though, have been accused of doing the opposite. He argues that, in the latter role, moneylender-landlords discourage the adoption of new agricultural technologies that would improve the lot of poor farmers since, ultimately, it would make farmers richer and reduce the demand for loans.

By keeping farmers perpetually in debt, Bhaduri argues, moneylenders strengthen their bargaining power in order to tighten the squeeze. Getting rid of moneylenders could actu- ally make matters worse for villagers if the moneylenders provide valuable and unique services. After all, moneylenders can charge high interest rates because at least some villagers are willing to pay them. Moreover, the high interest rates may largely reflect the high costs of doing business i. Those costs may not be small, particularly when potential borrowers do not offer seizable collateral, and when legal enforcement mechanisms are weak.

Braverman and Guasch , for example, estimate that the administrative costs of handling small loans range from 15 to 40 percent of loan size. Econ- omists focus on two features of markets above all else—their efficiency and their effects on the distribution of resources. Instead, only the most productive villagers should get access; those with mediocre prospects should be excluded at least if efficiency is the sole criterion. Specifically, all villagers should be given the chance to buy sewing machines if and only if their expected returns are greater than the cost of capital.

Imagine that it costs 20 cents per year for a bank to acquire each dollar of capital say, the bank has to pay 10 cents per dollar per year in interest to depositors and then cover 10 cents per dollar per year in administrative costs ; then loans should be given to all borrowers who can take the capital and earn more than 20 cents per dollar. In contrast, lending the money to someone who can only generate a return of 15 percent makes the pie smaller.

The ideas can be extended easily to accommodate risk. In the preceding scenario, we would want to lend only to those individuals with expected returns greater than 20 cents per dollar. This is ex ante efficiency, cap- turing the fact that judgments are made before knowing the actual out- comes of investments.

But if hypothetical success rates were any lower than 50 percent, it is no longer ex ante efficient to lend to them since capital costs are higher than expected returns. No matter whether monopolists are exploitative or not, it can be inef- ficient to have them around. In the case of credit markets, monopolists can charge interest rates well above their marginal cost of capital which we will assume is still 20 cents per dollar per year.

When this is the case, only the exceedingly productive villagers can afford to borrow to finance their investments; a wide range of otherwise worthy investment projects will go unfunded. Do high interest rates imply monopoly and inefficiency? Merely seeing interest rates of percent does not imply that moneylenders are monopolists; the rates may instead genuinely reflect how costly it is for moneylenders to acquire capital, to transact business, monitor clients, and accommodate risk. When default rates are high, money- lenders may have to charge a lot merely to stay afloat.

If this is the case, and if the moneylender is the only possible source of capital, the cause of efficiency will be furthered by only lending to the most productive villagers. Adams argues that this is indeed the case: Rural credit markets are far more competitive than typically imagined, and he cites studies that show that moneylenders are charging rates in accord with their transactions costs and risks. Even worse, if microfinance providers are inappropriately subsidized, they may squeeze out moneylenders, worsening overall access to financial services for poor households: Good intentions will have had perverse consequences Adams and von Pischke So sorting out the debate about moneylenders and market structure matters to whether supporting microfinance improves efficiency.

Bottomley uses a much-cited hypothetical example to argue that moneylender rates are plausibly competitive, and Basu , gives a comparison of two moneylenders in this spirit. Imagine one moneylender in the city and one in the countryside. Assuming away transactions costs and capital costs for now, the forces of competition will push the expected returns of the two moneylenders to be equal in a competitive setting.

The second moneylender expects that half of his customers will default.


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Looked at a different way, the example shows that default rates have to be 50 percent in order to explain interest rates of percent in this setting. This stylized example relies on the assumption that moneylenders can recover nothing at all from those who default, and it ignores oppor- tunity costs and transactions costs. To resolve debates, we need data. A broad range of careful case studies show that typical default rates are nowhere close to 50 percent, but transactions costs and opportunity costs are high. In 29 of the cases some part of the interest was not recovered, but this could explain only 23—43 percentage points of the overall interest rates charged.

In Pakistan, Aleem similarly finds 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. Singh argues that the high interest rates are mainly due to high opportunity costs, not to monopoly profits. With capital so scarce, he argues, if moneylenders invested their money directly in farm enter- prises they would earn net returns that average 77 percent per year.

The high 77 percent annual returns that the moneylenders can expect on their own farm invest- ments may themselves be partly due to monopoly profits since capital is scarce in general. Moreover, if borrowers use the funds for farm investments, they must be able to earn returns that are roughly twice as high as the moneylender just to be able to pay back loans with inter- est rates that average percent per year.

A larger issue concerns the structure of the market. Adams argues that markets are competitive since there is relatively free entry by locals if not by outside banks. A simple test of this assertion is to check whether the introduction of new funds into an area drives down interest rates as it should if markets are truly competitive.

Specialization by geog- raphy or other characteristics give lenders local monopolies that allow them to make profits in the short term. At the same time, there may be free entry into the market, so lenders may have difficulty maintaining profits over the long run.

To pursue this line, Aleem argues that only considering average costs misses the story. If markets are truly com- petitive, interest rates should be driven down to the marginal cost of lending—that is, the cost of lending an extra rupees, which is typ- ically below the average cost.

Aleem estimates that the cost of lending an extra rupees, though, is about 48 percent, which is considerably lower than the average cost. Steel et al. Most of the costs incurred by the moneylenders surveyed in Africa involve the pre- screening of clients. Once that is taken care of, administrative costs of handling loans—the largest element of the marginal cost of lending— is small equal to only 0. In perfectly com- petitive markets, interest rates should be driven down to the marginal cost, but clearly this has not happened in these cases.

The fact that marginal costs are below average costs is a hallmark of monopolistic competition, as is the fact that average costs match inter- est rates and that entry into the market is relatively free for insiders. In Chambar market, Aleem describes a situation in which there are too many moneylenders serving too few clients. As a result, moneylend- ers have difficulty covering the fixed costs of lending, and interest rates stay high because returns to scale cannot be reaped.

Although there is no evidence of exploitation of a kind stressed by Bhaduri , the market is inefficient and, in principle at least, interventions could yield a larger pie. Microfinance institutions, on the other hand, aim to serve many clients on a large scale, pushing exist- ing barriers out of the way as they proceed.

Before leaving these issues, we offer one more comment on Adams If a microfinance institution could find new ways to lend to those same villagers and charge 25, 50, or 75 percent, efficiency is improved: More projects get funded and the hardworking moneylender goes out of business in the name of progress.

The promise is that microfinance can indeed do better than what exists. Economists have histori- cally assumed that there is a trade-off between reaching distributional goals and efficiently allocating resources—the steady economic decline of the socialist economies is just the most dramatic recent example of the trade-off. But in a world with limited financial markets, there will not necessarily be a trade-off: Spreading access to financial services can both open opportunities for the poor and increase aggregate produc- tive efficiency.

Such discrimination manifests itself in credit markets, just as it does in labor markets. Overcoming discrimi- nation will yield a more just society—and possibly a richer one if excluded individuals have worthy investment projects that are going unfunded. In principle, then, taking resources from privileged households and using them to subsidize the financial access of excluded households can improve both equality and efficiency.

As described earlier, policy- makers need to be careful, though, since as the experience of large, sub- sidized state banks showed, some ostensibly pro-poor credit market interventions can be so inefficient that, in the end, everyone might lose. There may also be contexts in which concerns with efficiency and distribution run in opposite directions.

We have assumed previously implicitly that moneylenders charge all borrowers the same rate of interest. Moneylenders will hold back loans in order to maximize revenues, pushing up average interest rates in the local market. The outcome is inefficient since the quantity of capital is restricted. The savvy lender will raise interest rates just to the point at which each client is indifferent between borrowing or not, and the moneylender will then reduce the price by a small notch to convince clients to borrow.

Indeed, the moneylender is most successful if all productive borrowers get ample credit—as long as the moneylender can then grab the benefits. The moral is that even fully efficient informal markets can be improved by pro-poor interventions. The emerging evidence suggests important pro-poor impacts of microfinance, and in chapter 6 we return to issues of equity and dis- tribution in the context of subsidies. The rest of this chapter focuses on the problems that formal sector banks traditionally have when lending in poor regions, and it is efficiency that will be our first con- cern for now.

Consider a borrower and a lender. The borrower has a project, but no money to finance it; she must then turn to the lender. These information problems create inefficiencies, and microfinance can be seen as one attempt to overcome them. The information problems arise at three distinct stages. First, prior to extending a loan, the lender may have little if any reliable informa- tion about the quality of the borrower. Sometimes a bit of quick scout- ing around by a loan officer can yield the required information, but too often the necessary background research on borrowers is prohibitively costly.

Will the borrower work hard to ensure that the invest- ments are successful? Or might the borrower work less hard than he or she would if the project was entirely self-financed? Third, once investment returns have been realized, the lender may not be able to verify the magnitude of the returns. It is tempting then for the borrower to claim to have had bad luck and to ask for a reprieve in paying the loan when in fact the investment was highly profitable.

The absence of formal credit institutions in village economies is often attributed to these kinds of agency problems. They are accentuated when individuals cannot offer seizable collateral, and when legal enforcement mechanisms are weak. In what follows we describe the problems faced by a typical commercial bank, and in chapters 4 and 5 we describe microfinance solutions. Clients have no inherent loyalty to outside banks, and lenders have little information about potential clients.

De Soto has argued that the solution is to tackle the root of the problem by establishing formal titles to land and clear property rights over assets that make it easier for the poor to offer collateral. It also may run into stiff community opposition. In the analysis that follows, we assume that liability is limited: Bor- rowers cannot repay more than their current income. Banks, the argument goes, are therefore unable to discriminate against risky borrowers and interest rates become exceedingly high. Such rates in turn drive worthy borrowers out of the credit market.

The extent of the imperfection is mag- nified by the extent of limited liability. Note that the concern here is with the inherent riskiness of borrowers. Some may simply be more prudent, more conservative, better insured. Others may be risk-loving, may be poorly disciplined, or may face competing claims on their funds. When discussing moral hazard in section 2. We illustrate the mechanism with a simple example. Consider an economy populated by individuals who seek to maximize profits.

Individuals do not have wealth of their own, so they need to borrow to carry out their investment projects. When they are lucky, risky borrowers earn higher profits than safe borrowers. But when risky borrowers are not successful which happens with com- plementary probability 1- p , they earn zero and cannot repay the loan. The assumption allows us to focus on problems raised by the lack of information and collateral without having to worry about prob- lems created by monopoly as well.

Under competition, at minimum the bank tries to cover its gross cost, k, per unit lent. Suppose that even the low-revenue gross outcome exceeds the gross cost of capital i. We can then see that if the population was made up of only safe borrowers, the competitive bank will set the gross interest rate i. Things get more complicated when we consider the risky population too. When risky borrowers also apply for loans, the bank will want to charge them interest rates higher than k in order to compensate for the added risk.

The complication arises when the bank cannot ade- quately distinguish between safe and risky borrowers beforehand. If the lender only knows that a portion q of the loan applications come from safe borrowers and that a portion 1 - q comes from risky bor- rowers, the break-even gross interest rate of the lender will increase from k to Rb. Now we have to figure out what that rate Rb is—and what it means for the economy. Now, all borrowers, whether safe or risky, must pay this higher rate since the bank is unable to tell who is who. The problem is that Rb may rise so high that safe borrowers are discouraged from applying for loans.

That would be inefficient since, by assumption, both the risky and the safe borrowers have worthy projects and, in the best of all worlds, they should both be funded. The example is illustrated in figures 2. In figure 2.