Credit markets in developing countries differ substantially from their counterparts in OECD countries. Apart from the obvious differences in institutional development, technology and productivity which are both measures for and causes of underdevelopment, typ ical LDC credit markets have two main characteristics. Firstly, their financial systems are very small compared those in industrial economies. Secondly, developing countries are characterized by very big informal financial sectors that coexist with formal credit institutions. Interestingly, credit contracts differ highly between these two sectors and there seems to be only very limited inter-sector competition. The following paper ventures to explain the persistence of these peculiarities in rural credit markets1 using the model of asymmetric information in credit markets developed by Stiglitz and Weiss. By applying the model specifically to LDC credit markets I show that asymmetric information is among the major reasons for the underdevelopment of rural credit markets. Building on these findings I then explain how Microfinance Institutions (MFI) have lately been able to overcome some of the problems of imperfect information and strive in markets formerly dominated by informal money lenders.
The first part of this paper provides an overview of the typical characteristics of credit markets in developing countries, concentrating on the limited size of LDC credit markets and on the apparent dichotomy between formal and informal finance sectors. Then, the importance of financial systems for economic development is briefly outlined in order to explain the relevance of the topic of this essay. The main part of the paper then presents the model of asymmetric information in credit markets pioneered by Stiglitz/Weiss as a possible explanation for the causal origins of these characteristics. The last part shows how successful microfinance institutions may succeed in operating in rural credit markets by their ability to overcome problems of imperfect information.
Table of Contents
1. Introduction
2. Credit Markets in Developing Countries
2.1. Empirical Findings
2.1.1. The Size of Credit Markets
2.1.2. Informal Credit Markets
2.2. Financial Markets and Development
3. The Asymmetric Information Paradigm
3.1. The Stiglitz/Weiss Model
3.2. Application of the model to rural markets
4. Microfinance
5. Conclusion
Objectives and Core Themes
This paper examines the structural peculiarities of credit markets in developing countries, specifically focusing on the persistence of credit rationing and the dichotomy between formal and informal financial sectors. The primary research goal is to utilize the Stiglitz/Weiss model of asymmetric information to explain why these markets remain underdeveloped and how microfinance institutions can successfully bridge these gaps.
- Characteristics and constraints of credit markets in developing nations
- The role of financial systems in economic development
- The Stiglitz/Weiss asymmetric information paradigm
- Mechanisms of credit rationing, adverse selection, and moral hazard
- The impact of microfinance innovations on rural credit access
Excerpt from the Book
3.1. The Stiglitz/Weiss Model
In its most basic form, the model by Stiglitz and Weiss assumes a credit market with two groups, borrowers and lenders (banks). The borrowers engage in different investment projects and each project has a different probability distribution F(R,?) of returns R. However, of these characteristics the lender can only observe the mean return and not the probability distribution, i.e. information is distributed asymmetrically between borrowers and lenders. As lenders can observe the mean return, Stiglitz and Weiss make the simplifying assumption that all borrowers engage in projects with the same mean return, however the probability distribution of returns differs across borrowers, with a greater ? corresponding to greater risk.
Consequently, while there is a bottom to the risk that the borrower takes (his collateral C), there is no ceiling to his net returns. For a given value of r-hat, profits are therefore a convex function of R and expected profits increase with risk. Consequently, one can determine that for a given interest rate r-hat, there is a critical value of ?’ so that a firm borrows from the bank if and only if ?> ?’, i.e. the mix of borrowers becomes worse with increasing r-hat because at a certain point level of r-hat borrowers with less risk do not find the loan contract attractive.
Summary of Chapters
1. Introduction: Outlines the dualistic nature of credit markets in developing countries and introduces the application of the Stiglitz/Weiss model to explain their underdevelopment.
2. Credit Markets in Developing Countries: Provides empirical evidence regarding the small size of formal financial sectors and the prevalence of informal credit markets in rural areas.
3. The Asymmetric Information Paradigm: Details the theoretical framework of adverse selection and moral hazard, explaining why banks might choose to ration credit rather than increase interest rates.
4. Microfinance: Discusses how institutions use tools like progressive lending and group lending to overcome information asymmetries and improve market efficiency.
5. Conclusion: Summarizes the findings and argues that while microfinance mitigates information problems, broader institutional and political reforms remain necessary for development.
Keywords
Asymmetric information, credit rationing, developing countries, LDCs, informal credit markets, financial development, Stiglitz/Weiss model, adverse selection, moral hazard, microfinance, rural credit, financial intermediaries, economic growth, loan contracts, peer monitoring.
Frequently Asked Questions
What is the primary focus of this paper?
The paper focuses on explaining the structural inefficiencies and the persistent dichotomy between formal and informal credit markets in developing countries.
What are the key thematic areas?
The core themes include the impact of asymmetric information on lending, the nature of informal money lenders, and the role of microfinance as a developmental tool.
What is the central research question?
The research asks why formal credit sectors in developing countries fail to meet demand and why they do not compete effectively with informal sectors, using the lens of information asymmetry.
Which scientific method is utilized?
The author applies the theoretical Stiglitz/Weiss model of asymmetric information to analyze credit market behavior and evaluates empirical findings from various development studies.
What does the main body of the work cover?
The main body covers the empirical characteristics of LDC credit markets, the theoretical foundations of credit rationing, and practical innovations used by microfinance institutions.
What are the characterizing keywords of the study?
Key terms include asymmetric information, credit rationing, LDCs, microfinance, and moral hazard.
How does the Stiglitz/Weiss model explain credit rationing?
It posits that as interest rates rise, the average riskiness of the borrower pool increases due to adverse selection, causing banks to restrict the supply of loans to maintain profitability.
Why do informal money lenders dominate rural areas?
They possess superior local information and social capital, which allows them to effectively monitor borrowers and enforce contracts where formal banks cannot.
What role does 'progressive lending' play?
Progressive lending allows banks to mitigate adverse selection by offering larger loans only to borrowers who have demonstrated creditworthiness through previous, smaller repayments.
What is the significance of group lending in this context?
Group lending leverages community-level peer monitoring and social pressure to reduce moral hazard and align the risk-taking behavior of group members.
- Quote paper
- Patrick Avato (Author), 2005, Banks, Informal Money Lenders and Asymmetric Information , Munich, GRIN Verlag, https://www.grin.com/document/40080
