Question

Question 4 (15 marks) 10 Suppose we observe borrowers in a rural sector of a developing country borrowing from a moneylender, who is charging them a high interest rate, even though there exist other low-interest lenders (e.g., formal sector financial institutions). We can infer that borrowers are acting irrationally. Discuss the validity of this statement (5 marks) Furthermore, explain the Lender's Risk Hypothesis and analyze the formula that explains the need for the informal interest rate to be above formal sector rates. (10 marks)

Answer 1

(Ans 1)

A significant fraction of the credit transactions in the rural areas take place in the informal sector instead of the formal sector financial institutions. This is largely because the borrowers in the rural sector of developing country lack sufficient assets to put up as a collateral which is a prerequisite for borrowing from the banks. The reason behind this is that the informal credit market displays the features that are not observed in the formal sector institutions. This is because the informal lenders do not operate within the full range of the law and have greater flexibility on what they will accept as collateral.

1. In the informal sector, loans are advanced based on oral agreements, with little or no collateral, whereas, in the formal sector, bank loans require proper documentation and collateral which is rarely available with poor households.
2. Informal sources of credit, such as the moneylenders know the borrowers personally and are often willing to give them a loan without any collateral.
3. Sometimes, if the borrowers are unable to repay the loan amount, they can get additional loans from the moneylenders.
4. There is significant credit rationing, whereby borrowers are unable to borrow all they want, or some loan applicants are unable to borrow at all.

The formal sector credit sources on the other hand ignore the small farmers, lower-income households, and small-scale enterprises in favor of a larger-scale well off clientele which can satisfy their stringent loan conditions. The institutional lenders do not have much knowledge about the characteristics or the activities of their clientele. In the presence of uncertainty about the loan repayments and limited liability, there would be too much risk taken by the borrowers which the bank does not want. Even in the absence of limited liability, the borrowers who would be able to pay under all contingencies would be the rich who can provide the banks with higher collaterals.

Thus, there is a discrimination against the poor borrowers who then turn to the informal sector for loans.

(Ans 2)

According to the Lender’s Risk Hypothesis (LRH), the rural moneylender charges a higher interest rate when the probability of default on loan is higher. The essential feature of LRH model is that there is a single lending instrument that the lender can use, i.e., the interest rate.

The interest rates may be higher in rural areas where close contacts and lack of mobility make strategic default a lot more difficult.

Consider the following:

1. L total amount of funds lent;
2. r opportunity cost of funds;
3. i interest rate charged in competitive equilibrium in informal sector;
4. p fraction of loans repaid.

According to the zero-profit condition,

0 = 7(1+1) – 7(? + 1) = d.

This implies that yield (i) is given as follows:

1+r i = -

Now, if p = 1, then i = r. However, if p < 1 and r < 1, then we can observe that the informal interest rates are sensitive to default risk.

A larger amount to be repaid may lead to a greater risk of default. Some loans may never be made, because p is so low that interest rate premium (i > r) is so large that affects chances of default.

Let us suppose that a moneylender extends a loan to a borrower in rural area against a collateral.

Let,

1. i be the interest rate charged on the loan;
2. be the value of the collateral to the borrower;
3. be the value of collateral to the moneylender;
4. F be the loss to the borrower for default, beyond the value of collateral.

There are two possibilities:

1. Borrower is in the state of involuntary default and doesn’t have resources to repay loan.
2. Borrower may consider willful default. Loss Vs + F, gain not having to repay capital and interest.

The borrower will repay the loan if the following condition is satisfied:

(1 + i)L<Vs + F

Lender will prefer to be repaid if the following condition is met:

91<7(? + I)

Thus, the repayment is of interest to both the parties if we combine the above two equations:

Vo < Vs + F

This implies that the lender’s valuation must not exceed the borrower’s valuation by too much.

In a case where F = 0, .

VỀ <V,

If the inequality given above is not true, then the following must be true.

V > Vs + F

This means that when the borrower wants to repay the loan, the lender does not want that to happen. Lender prefers to receive the collateral instead of the loan repayment. Thus, the lender may take action so that the borrower defaults. To achieve this, the lender can set the interest rate i so high such that:

(1 + i)L>Vs + F

This explains why the interest rate charged by the lenders in the informal sector are higher than that changed by those in the formal sector.