Credit Markets in Developing Countries Using a simple model of lending under str

Question

Credit Markets in Developing Countries Using a simple model of lending under strategio default explain the following stylized facts about credit markets in developing countries - 1) high interest rates, 2) loan rationing, 3) different interest rates charged to different borrowers What are some of the salient features of microfinance institutions? Explain the rationale behind these features. While microfinance institutions help the poor in getting access to essential financial services, they are not likely to be a magic bullet to the problem of chronic poverty. Elaborate on this statement by providing evidence from the RCT studies

Explanation / Answer

Part-1

Strategic Default in credit market is disticnt situation in credit market characterized by intentional and voluntary default on any loan by the borrower which can be encouraged by either the borrower or the lender.Now,based on the Strategic Default Model in credit market for developing countries,high interest rates prevailing in the market could lead to increased probability of loan default by the borrower and thus issuance or enforcement of collateral is a common alternative for the lender.There are few factors which might incentivize or discourage loan default both for the lender and borrower based on respective economic costs and benefits.It must also be noted that there is a cost associated with default as well.Now,the collateral has a monetary value in the market and the timely interest payment has to be made on the total amount of the loan by the borrower if he/she decides to repay the loan and not default.Hence,if the monetary value of the collateral to be foregone and the cost of default in case the default option is chosen by the borrower is greater than the overall timely interest payment to be made on the loan,then the borrwer is better off paying the interest payment and decide against default option and vise versa as his economic cost from defaulting exceeds that of repayment.On the other hand,if the monetary value of the collateral paid by the borrower is greater than the timely interest payment paid on the loan,then the lender would prefer loan default on the part of the borrower.Observe that in this instance,the lender would economically benefit higher from recieving the value of the collateral from the borrower than the interest payment he/she would pay to the lender.

Secondly,loan rationing is characterized as a particular situation in the credit markets in developing countries where the lender refuses to grant a loan amount that is requested or preferred by the borrower at a particular ongoing interest rate.At that specific interest rate,the borrower might be willing to borrow a certain amount but the lender usually ends up reimbursing less than what is preferred by the borrower.Now,such conduct by the lender might be induced by the potential possibility of loan default by the borrower due to multiple factors such as low credit score,previous history of default,low periodic income level of the borrower and so forth.Hence,the desired loan amount can only be granted under higher interest rate than what is ongoing or prevailing in the market as higher interest rate would induce higher willingness for lending in the credit market.Loan Rationing can be commonly seen in rural credit markets in developing nations.

Thirdly,high probability of strategic default by the borrower can potentially induce credit market segmentation based on interest rate differentials.It implicitly signifie a higher level credit risk management through more stringent credit policies,frequent credit background check of the borrowers,credit tightening,enforcement of interest rates based on repayment probabilities and credit background check etc.Therefore,stragetic default in credit market can also cause a possible credit market volatility through market segmentation driven by interest rate differntial.Hence,interest rate is determined on an individual borrower basis and his personal financial/credit conditions and probability of default.

Part-2

The concept of microfinance basically refers to microcredit or microlending.It implies financial assistance through banks and legitimate financial institutions mainly to poor low income groups/individuals and underprivileged part of the society and is commonly witnessed in the rural sectors in many developing countries.Microfinancing has evidently emerged as one of the prominent financial measures to combat chronic poverty, accelerate economic development,ensure stable and equitable income distribution in the society,financial/economic independence of the poor and underprivileged in most developing countries.Some of the key elements or features of Microfiancing are discussed hereafter:-

i) The chief objective of microlending or financing is economic/financial betterment of the poor and low income group in the society and hence,majority of the beneficiaries of microfinancing in developing nations do not have any proper credit ranking or history as they do not have any proper access to credit markets due to infrastructural backwardness in these countries.Thus,microfinancing does not necessarily require any thorough or strict credit evaluation like any other regular commercial loans as again, it is primarily meant for underprivileged and poor section of the society.

ii) Microfinanciang can also be evidently accessible to poor and exploited farmers who are victimized by fradulent moneylending activities and other financial scams by unscrupulous rural money lenders.Thus,the debt level of microfinance beneficiaries might be considerably high with poor credit background as well.

iii) Considering the poor and volatile financial conditions of the applicants/beneficiaries,microfinancing usually does not require any collateral from the borrower and the loans are potentially unsecured.

iv) Since the poor and economically backward section of the society in developing and underdeveloped countries does not have much financial options and poor access to credit market,microfinancing is mostly offered to groups/individuals below poverty line.

v) Again,considering low credit ability and poor financial conditions of the applicants,on many occassions, microfinance loans usually charge low and reasonable interest rates.

vi) On some occassions,microfinance loans also come with microinsurance for the borrowers or applicants as it provides extensive credit protection for them.

vii) With attention to the limited educational and reading/writing abilities of the poor and underpriveleged applicants or borrowers,microfinancing provides easy and hassle free loan application process and formalities relared to loan documentation.

Part-3

Sporadic Randomized Control Trials(RCTs) have been conducted previously which are mainly intended to evaluate the overall economic efficacy or impact of the microfinancing in developing and underdeveloped countries.These are regarded as empirical studies on the effectiveness of micrifinance institutions in mitigating long term economic poverty,income equality and distributional equity,economic empowerment of the poor and backward section of the society and so forth.However,the results of these trial studies evidently fail to establish any concrete or untebale conclusion.It does not incontrovertibly prove that microfinancing has been completeley effective in reducing poverty at a comprehensive scale in developing and underdeveloped nations.

Nonetheless,the statistical or empirical validity of the RCTs has been questioned by several scholars and academicians as they tend to focus predominantly on a limited sample size from a localized area within a specific country.The low representativeness of the sampling of these studies hence provide limited and uncomprehensive statistical information and hence,cannot be regarded conclusive in general sense.Furthermore,RCTs do not establish any convincing causality between microfinancing and overall poverty level given the statistical/empirical limitations of these studies.In other words,it does not ideally offer any direct statistical link between these two phenomenon.Thus,RCTs evidently fail to establish any empirical connection between the microfinancing and long term poverty in many countries and on the other hand,it cannot be stated that microfinancing is indeed the subsequent long term solution to chronic poverty in developing and underdeveloped nations.

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