1. Justifying Interventions In Credit Markets For The Poor Last class: poor could potentially finance viable investment projects via informal institutions But informal institutions often charge exceedingly high interest rates And development banks were created to mitigate this problem →not a good strategy with some exceptions (Burgess –Pande (2004) Microfinance: small loans extended to poor individuals (mostly women) without collateral Today’s class: Justification for intervention in microfinance based on capital market imperfections

2. First: Interventions could be justified on efficiency and equity grounds And both can potentially improve if the following capital market imperfections can be circumvented: (1) Adverse selection (2) Ex ante moral hazard (3) Ex post moral hazard (4) Enforcement

3. (1) Adverse Selection Lenders lack information about borrower’s “types” (i.e., safe or risky) Suppose that efficiency dictates that both types “invest” But lenders are unable to distinguish between safe and risky borrowers → interest rates increase for both types And at such high interest rates safe exit the credit market and do not invest when efficiency dictates otherwise

7. 2) Ex Ante Moral Hazard Once a loan is disbursed Costly effort by the borrower cannot be observed by the lender Unless she is monitored (which is costly), the borrower may decide against putting effort But no effort → high probability of low return → default Borrower cannot commit not to “shirk” Particularly in the presence of (a) Limited liability (b) No collateral → A large number of “hard working” individuals would be denied access to credit when efficiency will dictate otherwise

8. 3) Ex Post Moral Hazard Borrowers may default “strategically” Unless costly verification of return realizations is undertaken by the lender → Lender may decide to lend at a “high” interest rates or not to lend at all →Honest individuals may end up paying exceedingly high interest rates or not requesting a loan (↓ investment) →The outcome is inefficient

9. 4) Enforcement Assume lenders have “hard” evidence on return realizations high enough But enforcement is either too costly or not feasible Borrowers default Lacking “technology” to enforce repayment → High risk → interest rates too high →Impediment for lenders to extend loans at affordable interest rates

10. Subsidies can be potentially justified on efficiency and equity grounds However, subsidies via development banks failed Need for “smart” interventions Such subsidies to microfinance: a potential solution And A-M (2005) argue that microfinance success traced back to informal informal credit (moneylenders, credit cooperatives, ROSCAs…) Why? Because credit can potentially overcome credit market imperfections← Next class emphasis on ROSCAs and Credit Cooperatives

11. Assume for the moment that this is indeed the case, then, how can one justify intervention in microfinance? Various arguments: Infant industry Women a) equity b) main brokers of health and education →Look into this later in the course: A-M (2005) Chapters 7 → For next class: A-M (2005) Chapter 3