Strategic interaction in undeveloped credit markets

This paper studies the strategic interaction between informal and formal lenders in undeveloped credit markets. In a model with adverse selection, loan seniority, market power, and differences in the cost of lending, it is shown that under general conditions a co-funding equilibrium will be a Nash outcome of the game. We demonstrate that a collateral requirement in connection with formal loans always generates a new co-funding equilibrium in which both lenders earn higher profits. A government subsidy to the formal lender may have the opposite effect. We relate our results to existing empirical evidence and the emerging discussion of how to best ensure financial viability and outreach of microfinance institutions.     

Repayment performance in group lending: Evidence from Jordan

Using data from a survey of 160 urban borrowing groups of the Microfund for Women in Jordan, we investigate the effect of screening, peer monitoring, group pressure, and social ties on borrowing groups' repayment behavior as an indirect test of different theoretical models. The dependent variable used captures the intensity of default measured by the total number of days of late repayment after each due date, allowing us to use count data models with cluster standard errors. As theory predicts, our empirical analysis suggests that peer monitoring, group pressure, and social ties reduce delinquency. The paper uncovers interesting evidence about the role of social ties and religion. Most notably, in an area where religion contributes to attitudes and beliefs of individuals, we find that religiosity improves repayment performance.     

Insurance,credit, and technology adoption: Field experimental evidencefrom Malawi

Does production risk suppress the demand for credit? We implemented a randomized field experiment to ask whether provision of insurance against a major source of production risk induces farmers to take out loans to adopt a new crop technology. The study sample was composed of roughly 800 maize and groundnut farmers in Malawi, where by far the dominant source of production risk is the level of rainfall. We randomly selected half of the farmers to be offered credit to purchase high-yielding hybrid maize and groundnut seeds for planting in the November 2006 crop season. The other half of farmers were offered a similar credit package, but were also required to purchase (at actuarially fair rates) a weather insurance policy that partially or fully forgave the loan in the event of poor rainfall. Surprisingly, take-up was lower by 13 percentage points among farmers offered insurance with the loan. Take-up was 33.0% for farmers who were offered the uninsured loan. There is suggestive evidence that reduced take-up of the insured loan was due to farmers already having implicit insurance from the limited liability clause in the loan contract: insured loan take-up was positively correlated with farmer education, income, and wealth, which may proxy for the individual's default costs. By contrast, take-up of the uninsured loan was uncorrelated with these farmer characteristics.     

Portfolio choice and pricing in illiquid markets

This paper studies portfolio choice and pricing in markets in which immediate trading may be impossible. It departs from the literature by removing restrictions on asset holdings, and finds that optimal positions depend significantly and naturally on liquidity: When expected future liquidity is high, agents take more extreme positions, given that they do not have to hold those positions for long when they become undesirable. Consequently, larger trades should be observed in markets with more frequent trading. Liquidity need not affect the price significantly, however, because liquidity has offsetting impacts on different agents' demands. This result highlights the importance of unrestricted portfolio choice. The paper draws parallels with the transaction-cost literature and clarifies the relationship between the price level and the realized trading frequency in this literature.     

The supply- and demand-side impacts of credit market information

We utilize a unique pair of experiments to isolate the ways in which reductions in asymmetric information alter credit market outcomes. A Guatemalan microfinance lender gradually started using a credit bureau across its branches without letting borrowers know about it. One year later, we ran a large randomized credit information course that described the existence and workings of the bureau to the clients of this lender. This pairing of natural and randomized experiments allows us to separately identify how new information enters on the supply and the demand sides of the market. Our results indicate that the credit bureau generated large efficiency gains for the lender, and that these gains were augmented when borrowers understood the rules of the game. The credit bureau rewarded good borrowers but penalized weaker ones, increasing economic differentiation.     

Financial liberalization,private investment and portfolio choice: Financialization of real sectors in emerging markets

Using firm level panel data, we analyze the impacts of rates of return gap between financial and fixed investments under uncertainty on real investment performance in three emerging markets, Argentina, Mexico and Turkey. Employing a portfolio choice model to explain the low fixed investment rates in developing countries during the 1990s, we suggest that rather than investing in irreversible long-term fixed investments, firms may choose to invest in reversible short-term financial investments depending on respective rates of returns and the overall uncertainty in the economy. The empirical results show that increasing rates of return gap and uncertainty have an economically and statistically significant fixed investment reducing effect while the opposite is true with respect to financial investments.     

Adverse selection in credit markets and regressive profit taxation

In many countries, taxes on businesses are less progressive than labor income taxes. This paper provides a justification for this pattern based on adverse selection that entrepreneurs face in credit markets. Individuals choose between becoming entrepreneurs or workers and differ in their skill in both of these occupations. I find that endogenous cross-subsidization in the credit market equilibrium results in excessive (insufficient) entry of low-skilled (high-skilled) agents into entrepreneurship. This gives rise to a corrective role for differential taxation of entrepreneurial profits and labor income. In particular, a profit tax that is regressive relative to taxes on labor income restores the efficient occupational choice.     

Vertical integration and investor protection in developing countries

The industrial organization of developing countries is characterized by the pervasive use of subcontracting arrangements among small, financially constrained firms. This paper asks whether vertical integration relaxes those financial constraints. It shows that vertical integration trades off the benefits of joint liability against the costs of rendering the supply chain more opaque to external investors. In contrast to the commonly held view that pervasive input and capital market imperfections are conducive to vertical integration, the model predicts that the motives for vertical integration are not necessarily higher in developing countries. In particular, vertical integration is more likely to arise at intermediate levels of investor protection and better contract enforcement with suppliers reduces vertical integration only if financial markets are sufficiently developed. Evidence supporting both predictions is discussed.     

Feedback effects between credit ratings and financial markets

Credit rating agencies often make sharp adjustments in their pronouncements during times of stress in financial markets. These adjustments typically happen with a delay relative to shocks in market prices. Since prices convey information about what market participants are doing and thinking, it is likely that rating agencies take into account market prices when issuing their pronouncements.In order to understand the relationship between credit ratings and financial prices, we develop a model of debt roll-over in which rating agencies incorporate information publicly available in financial markets. We find that (1) rating agencies respond to market prices, i.e. nonfundamental price volatility can shift financing conditions from a low risk spread and high credit rating equilibrium to an equilibrium with high spread and low rating, and (2) rating agencies can anchor expectations about the equilibrium in financial markets, thus serving as an antidote to nonfundamental price volatility.     

Financial constraints and investment: assessing the impact of a World Bank credit program on small and medium enterprises in Sri Lanka

Abstract.  This paper examines the investment behaviour of a sample of small, credit-constrained firms in Sri Lanka. Using a unique panel data set, we analyze and compare the activities of two groups of small firms distinguished by their differential access to financing; one group consists of firms with subsidized loans from the World Bank, while the other group consists of firms without such subsidies. The paper shows that the program led to higher levels of investment for financially constrained firms. However, the evidence is inconclusive on whether the program improved economic efficiency.     

The tradeoff between risk sharing and information production in financial markets

The production of information in financial markets is limited by the extent of risk sharing. The wider a stock's investor base, the smaller the risk borne by each shareholder and the less valuable information. A firm which expands its investor base without raising capital affects its information environment through three channels: (i) it induces incumbent shareholders to reduce their research effort as a result of improved risk sharing, (ii) it attracts potentially informed investors, and (iii) it may modify the composition of the base in terms of risk tolerance or liquidity trading. Implications for individual firms and the market as a whole are derived.     

Microfinance and competition for external funding

In this paper we examine a one-period model in which poverty minimizing microfinance lenders must raise external funding from a profit maximizing investor. Assuming that the lenders vary in their operating costs, we find that competition between lenders for external funds can lead to higher aggregate poverty reduction.     

Is life more risky in the open? Household risk-coping and the opening of China's labor markets

This paper uses a unique panel of data from rural China to analyze the impact of expanding connections to off-farm labor markets on the income and consumption of farm households. With stronger village ties to both migrant and local off-farm labor markets, households in previously autarkic village communities experience reduced exposure to shocks affecting agricultural production. The analyses presented in this paper control for the persistent effect of past shocks influencing income and consumption, household attrition potentially correlated with shocks, and endogeneity of household demographic composition, land holdings and village network connections to migrant and local labor markets.     

Herding effects in order driven markets: The rise and fall of gurus

We introduce an order driver market model with heterogeneous traders that imitate each other on a dynamic network structure. The communication structure evolves endogenously via a fitness mechanism based on agents performance. We assess under which assumptions imitation, among noise traders, can give rise to the emergence of gurus and their rise and fall in popularity over time. We study the wealth distribution of gurus, followers and non followers and show that traders have an incentive to imitate and a desire to be imitated since herding turns out to be profitable. The model is then used to study the effect that different competitive strategies (i.e. chartist & fundamentalist) have on agents performance. Our findings show that positive intelligence agents cannot invade a market populated by noise traders when herding is high.     

Here today,gone tomorrow: Can dynamic incentives make microfinance more flexible?

This paper presents a model of microfinance lending to individuals that uses dynamic incentives, in the form of access to additional loans, to discourage borrowers from strategic default, or the unwillingness to repay a loan once a positive outcome is realized. We propose an improvement on contracts currently used by microfinance institutions (MFIs) by endogenizing the default penalty, while constraining the MFI to maintain sustainable lending operations. Furthermore, accounting for the risks that the poor face by including a negative economic shock, we show that under certain circumstances, the punishment for default need not be a lifetime without loans.     

Aggregation, efficiency and mutual fund separation in incomplete markets

Summary. This paper studies the conditions for aggregation, portfolio separation and effective completeness of competitive allocations in general equilibrium models with incomplete markets where agents have general preference and endowment distributions. We show that these properties are distinct. Demands may aggregate yet may fail to exhibit fund separation and conversely. Fund separation implies effective completeness while aggregation does not. The implications of these properties for the structure of equilibria are discussed, and generalizations of the CAPM, the consumption CAPM and the CAPM with nonmarketed wealth emerge from the analysis. Received: September 12, 1996; revised version: November 7, 1996     

Designing credit agent incentives to prevent mission drift in pro-poor microfinance institutions

Credit agents in microfinance institutions (MFIs) must be given incentives to acquire information on potential borrowers and select them in accordance with the MFI's objectives. We show that while giving incentives has no cost in for-profit MFIs, it is costly in pro-poor MFIs: When repayment and wealth are positively correlated, a pro-poor MFI cannot obtain the selection of poor clients in the proportion it wishes with incentives based solely on repayment. It then becomes necessary to audit the share of very poor borrowers selected by an agent in order to provide the latter with adequate incentives. When audit costs are large, pro-poor MFIs may have to forego selection on wealth — and use other targeting devices such as working in impoverished geographical locations. Driven by donor concerns with ‘mission drift’ away from the poor, audits on the wealth status of clients have been introduced at the level of MFIs. We show that introducing pro-poor incentives requires extending such audits to the level of credit agents.     

Inducing liquidity in thin financial markets through combined-value trading mechanisms

Asset pricing theory hypothesizes that investors are only interested in portfolios; individual securities are evaluated only in terms of their contribution to portfolio risk and return. Yet, standard financial market design is that of parallel, unconnected markets, whereby investors cannot submit orders in one market conditional on events in others. When markets are thin, this exposes them to substantial execution risk. Fear of ending up with unbalanced portfolios after trading may even keep investors from submitting orders, further eroding liquidity and the ability of markets to equilibrate. The suggested solution is a portfolio trading mechanism referred to as combined-value trading (CVT). Investors are allowed to submit orders for packages of securities and the system matches trades and computes prices by optimally combining portfolio orders in an open book. We study the performance of the CVT mechanism experimentally and compare it to the performance of parallel, unconnected double auctions in experiments with similar parametrization and either a similar number of subjects or substantially thicker markets. We present evidence that our portfolio trading mechanism facilitates equilibration to the extent that the thicker markets do. Inspection of order submission and trade activity reveals that subjects manage to exploit the direct linkages between markets enabled by the CVT system.     

Financial markets, the pattern of industrial specialization and comparative advantage: Evidence from OECD countries

Due to underlying technological and organizational differences, industries differ in their need for external finance. Since services provided by the financial sector are largely immobile across countries, the pattern of industrial specialization should be influenced by the level of financial development. Among OECD countries we find a strong causal effect of the financial sector on industrial specialization. Further, the financial sector is a source of comparative advantage in a way consistent with the Hecksher-Ohlin-Vanek model. Results are also presented on which aspects of financial systems are important for specialization and comparative advantage.     

Estimates of gender differences in firm’s access to credit in Sub-Saharan Africa

Based on firm level data from 16 Sub-Saharan African countries we show how three different measures of credit constraints lead to three different estimates of gender differences in manufacturing firms’ credit situation. Using a perception based credit constraint measure female owned firms appear relatively more constrained than male owned firms. Using formal financial access data we find no gender effect. Finally, using direct information on credit constraints, male owned small firms appear disadvantaged. Furthermore we show a strong size gradient in the gender gap for the two measures for which we find significant gender differences.