Financial Development, Financing Choice and Economic Growth

In an overlapping generations economy, households (lenders) fund risky investment projects of firms (borrowers) by drawing up loan contracts on the basis of asymmetric information. An optimal contract entails either the issue of only debt or the issue of both debt and equity according to whether a household faces a single or double enforcement problem as a result of its own decision about whether or not to undertake costly information acquisition. The equilibrium choice of contract depends on the state of the economy which, in turn, depends on the contracting regime. Based on this analysis, the paper provides a theory of the joint determination of real and financial development, with the ability to explain both the endogenous emergence of stock markets and the complementarity between debt finance and equity finance.     

BANKRUPTCY AND DELINQUENCY IN A MODEL OF UNSECURED DEBT

This article documents and interprets a fact central to the dynamics of informal consumer debt default. We observe that for individuals 60– 90 days late on payments, (i) 85% make payments during the next quarter, and (ii) 40% reduce their debt. To understand these facts, we develop a quantitative model of debt delinquency and bankruptcy. Our model reproduces the dynamics of delinquency and suggests an interpretation of the data in which lenders frequently reset loan terms for delinquent borrowers, typically offering partial debt forgiveness, instead of a blanket imposition of the “penalty rates” most unsecured credit contracts specify.     

Endogenous growth and the emergence of equity finance

This paper characterises the development of equity markets as a dynamic process that both influences and is influenced by the development of the real sector of the economy. In overlapping generations, economy borrowers seek funds to run risky investment projects by drawing up contracts which may take the form of either equity or debt issue. In the presence of information asymmetry between borrowers and lenders, the optimal contract is determined by trading off information dilution costs against bankruptcy costs. Significantly, the equilibrium choice of contract depends on the state of the economy which, in turn, depends on the contracting regime. Based on this analysis, the paper provides a theory of the joint determination of real and financial development with the ability to explain the emergence of a stock market along the path of real development.     

Collusion and group lending with adverse selection

In an environment with correlated returns, this paper characterizes optimal lending contracts when the bank faces adverse selection and borrowers have limited liability. Group lending contracts are shown to be dominated by revelation mechanisms which do not use the ex post observability of the partners' performances. However, when collusion between borrowers under complete information is allowed, group lending contracts are optimal in the class of simple revelation mechanisms (which elicit only the borrower's own private information) and remain useful with extended revelation mechanisms.     

Risk aversion and incentive compatibility with ex post information asymmetry

Summary. The paper extends Diamond's (1984) analysis of financial contracting with information asymmetry ex post and endogenous “bankruptcy penalties” to allow for risk aversion of the borrower. The optimality of debt contracts, which Diamond obtained for the case of risk neutrality, is shown to be nonrobust to the introduction of risk aversion. This contrasts with the costly state verification literature, in which debt contracts are optimal for risk averse as well as risk neutral borrowers. Received: December 7, 1998; revised version: June 9, 1999     

The equilibrium allocation of investment capital in the presence of adverse selection and costly state verification

Summary We consider credit rationing in an environment with adverse selection and costly state verification. The presence of costly state verification permits debt contracts to emerge under conditions that we specify. When debt contracts are observed, so is credit rationing. This rationing occurs even if it is possible for rationed borrowers to bid up expected returns to lenders and hence is voluntary. We also show how the adverse selection and costly state verification problems interact and investigate how improvements in information gathering technology impact on the extent of credit rationing.The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. We have benefitted from comments on an earlier draft of this paper by Franklin Allen, Charlie Calomiris, V. V. Chari, Ed Green, Craig Holden, Jeff Lacker, George Pennachi, Neil Wallace, Anne Villamil, and an anonymous referee and from discussions with Edward Prescott.     

The desire for land: Strategic lending with adverse selection

This paper deals with a setting in which borrowers and lenders place different values on an asset that can be used as collateral. Under adverse selection, lenders may rationally choose credit contracts with the object of attracting a relatively risky group of clients, so raising their chances of gaining possession of the asset through default. Contracts of differing attractiveness to borrowers can also coexist in equilibrium. When an ‘inside’ and an ‘outside’ lender compete, the latter placing a lower value on the collateral, and their loanable funds are sufficiently limited, a separating equilibrium may exist in which the insider offers a contract which attracts risky borrowers, whereas the outsider's contract is aimed at a safer group. If loanable funds are ample, the only equilibrium will involve pooling contracts, but the insider may still offer more attractive contracts in an entry game.     

Competition and microfinance

Competition between microfinance institutions (MFIs) in developing countries has increased dramatically in the last decade. We model the behavior of non-profit lenders, and show that their non-standard, client-maximizing objectives cause them to cross-subsidize within their pool of borrowers. Thus when competition eliminates rents on profitable borrowers, it is likely to yield a new equilibrium in which poor borrowers are worse off. As competition exacerbates asymmetric information problems over borrower indebtedness, the most impatient borrowers begin to obtain multiple loans, creating a negative externality that leads to less favorable equilibrium loan contracts for all borrowers.     

Competitive equilibrium in the credit market under asymmetric information

We study a competitive credit market equilibrium in which all agents are risk neutral and lenders a priori unaware of borrowers' default probabilities. Admissible credit contracts are characterized by the credit granting probability, the loan quantity, the loan interest rate and the collateral required. The principal result is that in equilibrium lower risk borrowers pay higher interest rates than higher risk borrowers; moreover, the lower risk borrowers get more credit in equilibrium than they would with full information. No credit is rationed and collateral requirements are higher for the lower risk borrowers.     

INCOME DISTRIBUTION, SOVEREIGN DEBT, AND PUBLIC INVESTMENT

We develop a political economy model of sovereign debt that shows that income inequality leads to popular pressures on the government to use foreign debt to finance a redistribution of income at the expense of productive public investment. Recognizing this fact, international lenders impose credit ceilings with the consequence that developing country borrowers invest less and grow slower.     

Are the credit ratings assigned by bankers based on the willingness of LDC borrowers to repay?

This paper examines whether the credit ratings assigned by the lenders can be explained using a set of explanatory variables selected from the willingness of LDC borrowers to repay their debt service obligations. The results indicate that first, the credit ratings provide a reasonable measure of borrower's creditworthiness and second, the set of the explanatory variables included in the study is significant in explaining variations in the credit ratings. Furthermore, inclusion of dummy variables for geographical location of borrowers, degree of indebtedness, and absolute size of debt suggests that there may be a significant group contagion in assigning credit ratings.     

A dynamic model of unsecured credit

We study the terms of credit in a competitive market in which sellers (lenders) are willing to repeatedly finance the purchases of buyers (borrowers) by engaging in a credit relationship. The key frictions are: (i) the lender cannot observe the borrower?s ability to repay a loan; (ii) the borrower cannot commit to any long-term contract; (iii) it is costly for the lender to contact a borrower and to walk away from a contract; and (iv) transactions within each credit relationship are not publicly observable. The lender?s optimal contract has two key properties: delayed settlement and debt forgiveness. Finally, we study the impact of changes in the initial cost of lending on the contract terms.     

Information, Informal Finance, and SME Financing

Informal finance exists extensively and has been playing an important role in small- and medium-sized enterprise (SME) financing in developing economies. This paper tries to rationalize the extensiveness of informal finance. SME financing suffers more serious information asymmetry to the extent that most SMEs are more opaque and can only provide less collateral. Informal lenders have an advantage over formal financial institutions in collecting “soft information” about SME borrowers. This paper establishes a model including formal and informal lenders and high- and low-risk borrowers with or without sufficient collateral and shows that the credit market in which informal finance is eliminated will allocate funds in some inefficient way, and the efficiency of allocating credit funds can be improved once informal finance is allowed to coexist with formal finance. Translated from Economic Research Journal, 2005, 7 (in Chinese)     

Optimal debt contracts and moral hazard along the business cycle

Summary. We analyze the Pareto optimal contracts between lenders and borrowers in a model with asymmetric information. The model generalizes the Rothschild-Stiglitz pure adverse selection problem by including moral hazard. Entrepreneurs with unequal abilities borrow to finance alternative investment projects which differ in degree of risk and productivity. We determine the endogenous distribution of projects as functions of the amount of loanable funds, when lenders have no information about borrowers ability and technological choices. Then, we embed these results in a dynamic competitive economy and show that the average quality of the selected projects in equilibrium may be high in recessions and low in booms. This phenomenon may generate (a) multiple steady states, (b) a smaller impact of exogenous shocks on output relative to the full information case, (c) endogenous fluctuations.Received: 11 June 2001, Revised: 17 June 2003, JEL Classification Numbers: A10, G14, G20, E32.Correspondence to: Pietro ReichlinPietro Reichlin acknowledges financial support from MURST and Paolo Siconolfi acknowledges financial support from the GSB of Columbia University.     

The redistributive effects of inflation and of the introduction of a real tax system in the U.S. bond market

This paper investigates which types of borrowers and lenders in the U.S. bond market gain (or lose) as result of the interaction of inflation with a nominal and discriminating tax structure. It is shown that an increase in the rate of inflation favors tax exempt institutions, and probably other lenders too. Corporate borrowers probably gain while mortage borrowers probably lose. The paper also investigates the one shot redistributive effects of indexing the tax structure. It is shown that the reform hurts tax exempt institutional investors and, probably, other lenders too. It hurts corporate borrowers and probably favors state and local governments and mortgage borrowers.     

A pricing model with dynamic repayment flows for guaranteed consumer loans

In the literature, the pricing of guaranteed consumer loans remains largely unexplored. This paper proposes a pricing model with dynamic repayment flows for guaranteed consumer loans based on the expected net present value (ENPV) method. Our study contributes to the literature by providing a practical guide for individual lenders to invest in consumer loans. Specifically, we conduct an illustrative analysis of peer-to-peer consumer loans guaranteed by the Risk Protection Scheme (RPS) in China. The ENPV shows that the value of guaranteed loans is jointly determined by the borrowers’ Markov repayment behavior and the compensation ability of the RPS. Numerical simulations show that both the returns and losses of guaranteed loans are smaller than those of non-guaranteed loans. Further, the lenders who invest in a loan guaranteed by the RPS receive some repayments, although the borrower no longer repays the debt and the balance of the guarantee account is negative.     

Long-run Growth and Intragenerational Transfer Under Capital Market Imperfections

The purpose of this paper is to provide a long-run growth model linking growth to income distribution between lenders and borrowers in an environment where enforcement of loan contracts is imperfect. The equilibrium under costly verification implies a smaller growth rate, relative to the symmetric-information economy. Intra-generational transfer of income is shown to promote growth so long as the redistribution gives rise to an increase in net worth positions of borrowers.
JEL Classification Numbers: G21, O16, O40     

Screening by the Company You Keep: Joint Liability Lending and the Peer Selection Effect

We look at an economic environment where borrowers have some information about the nature of each other's projects that lenders do not. We show that joint-liability lending contracts, similar to those used by credit cooperatives and group-lending schemes, will induce endogenous peer selection in the formation of groups in a way that the instrument of joint liability can be used as a screening device to exploit this local information. This can improve welfare and repayment rates if standard screening instruments such as collateral are unavailable.     

Access to capital in rural Thailand: An estimated model of formal vs. informal credit

This paper analyzes the mechanism underlying access to credit, focusing on two important aspects of rural credit markets. First, moneylenders and other informal lenders coexist with formal lending institutions such as government or commercial banks, and, more recently, micro-lending institutions. Second, potential borrowers presumably face sizable transaction costs in obtaining external credit. We develop and estimate a model based on limited enforcement and transaction costs that provides a unified view of these facts. Based on data from Thailand, the results show that the limited ability of banks to enforce contracts, more than transaction costs, is crucial in understanding the observed diversity of lenders.     

信息、非正规金融与中小企业融资

各种形式的非正规金融在发展中国家和地区广泛存在。本文认为,由于中小企业信息不透明,且常常不能提供充分的担保或抵押,正规金融机构难以有效克服信息不对称造成的逆向选择问题,而非正规金融则在收集关于中小企业的“软信息”方面具有优势。这种信息优势是非正规金融广泛存在的根本性原因,金融抑制只是一个强化因素,同时非正规金融市场的各种特征也都源于其存在的根本逻辑。本文构建了一个包括异质的中小企业借款者和异质的贷款者(具有不同信息结构的非正规金融和正规金融部门)的金融市场模型,证明非正规金融的存在能够改进整个信贷市场的资金配置效率。