14.1.

Introduction
14.1.1 The limit to credit and Insurance.
credit and insurance are shown as crucial for economic activities. However, they face
challenges like loan defaults and verifying insurance claims. In smaller communities, informal
insurance schemes exist but lack enforceability. Overall, strong participation incentives are
needed for these systems to work effectively.

14.1.2. Sources of demand for credit

Credit is divided into three main types: fixed capital for big investments like factories,
working capital for everyday expenses in production, and consumption credit for personal
needs like medical emergencies or celebrations. Especially in agriculture, working capital is
vital because farmers often need money upfront for seeds and supplies before they can sell
their crops. In addition to seasonal challenges, uncertainty in agriculture makes consumption
credit important for smoothing out income fluctuations and helping people cover expenses
during tough times.

14.2. Rural credit markets

14.2.1. Who provides rural credit?
 Institutional lenders: Formal lenders like government banks, commercial banks,
and credit bureaus play a significant role in providing credit. However, they often lack
personal knowledge about their clients' activities, making it challenging to monitor
how loans are used.

1. Divergence of Interests: There can be a mismatch of interests between

borrowers and lenders, especially in uncertain situations. For example,
borrowers may divert loans to riskier projects with potentially higher returns,
which may not align with lenders' preferences.
2. Limited Liability and Risk-taking: Limited liability of borrowers can lead to a
tendency to take on excessive risk. In uncertain scenarios, borrowers may
benefit if projects succeed but are protected from losses if projects fail. This
creates a situation where borrowers may seek riskier projects, which may not
be desirable for lenders.
3. Credit Rationing: Banks may ration credit to mitigate risks associated with
limited liability and ensure repayment. This can disproportionately affect poor
borrowers who may lack acceptable collateral for loans.
Credit Rationing is when banks limit the amount of money they lend to people to
reduce the risks they face. They do this because some borrowers might not be able
to repay the loans, especially if they don't have much to offer as collateral (like
property or assets). This can be tough for poor borrowers because they might not
have enough valuable things to offer as collateral, so they might not get the loans
they need.
 4. Collateral Requirements: Institutional credit agencies often require collateral
before providing loans. While this may be reasonable for banks to mitigate
risks, it can make formal credit inaccessible to poor individuals whose
collateral may not meet the requirements set by lenders. For example, a
farmer may have land to mortgage, but it may not be considered acceptable
collateral by the bank due to the cost associated with selling the land in case
of default. Similarly, a landless laborer may pledge their labor as collateral, but
banks may not accept this form of collateral.

 Informal lenders:

 informal moneylenders, like landlords or shopkeepers, might accept unusual

forms of collateral, such as a small piece of land or a promise to work. They
also tend to know more about the people they lend to. For example, a
shopkeeper who lends money to a farmer may take part of the farmer's
harvest as repayment. This makes informal moneylenders more popular in
rural areas, even when the government tries to promote formal banking.
 For example, in India, despite efforts to increase formal rural credit, a large
percentage of borrowing still happens from informal moneylenders. In
Thailand, while the informal sector's share of rural credit decreased over time,
it still remained significant. In some countries like Nigeria, most people rely
entirely on informal moneylenders.

14.2.2. Some characteristics of rural credit markets

1. Imperfect Credit Markets: If credit markets were perfect, we wouldn't need
to discuss this. But rural credit markets are far from perfect. They don't work
smoothly like we'd hope.
2. Information Gap: One big problem is the lack of information. Lenders often
don't know what borrowers will use the money for or if they'll be able to pay it
back.
3. Segmentation: Rural credit markets are divided into segments. Moneylenders
usually stick to lending within their own circle of clients, often from the same
village. They prefer lending to people they know well.
4. Interlinked Transactions: Often, credit is linked with other economic
activities. For example, landlords may lend to their tenants or traders to those
they buy goods from.
5. Interest Rate Variation: Informal interest rates on loans can vary a lot
depending on where you are, who you borrow from, and who you are.
Sometimes they're really high, sometimes not. But they're not always what
they seem.
 6. Rationing: Borrowers often can't get as much money as they want from
lenders, even if they're willing to pay higher interest. This is strange because
lenders could make more money by lending more.
7. Exclusivity: Lenders often want borrowers to deal with them only, not with
other lenders. They create a kind of local monopoly where they control who
gets loans and how much they get.
segmentation focuses on the division of the credit market into different groups, while
exclusivity deals with the control exerted by lenders over borrowers, ensuring they only
borrow from one source.

14.3. Theories of informal credit markets

14.3.1. Lender’s monopoly
1) while it's true that lenders in rural areas often have significant control over their clients,
leading to high interest rates, it's not accurate to assume they have complete monopoly
power. Research shows that while credit markets may be segmented, there are usually
multiple lenders available. While lenders may have local dominance, it's not absolute
monopoly power

2) Even if a lender has significant control over borrowers, it doesn't always mean they charge
high interest rates. In fact, there are more efficient ways to generate profits in money lending.

14.3.2. The lender’s risk hypothesis

A somewhat more satisfactory explanation of high interest rates is provided by
the lender’s risk hypothesis. this hypothesis maintains that lenders earn no
(ex-ante) return on their money over and above their opportunity cost.
This risk comes from many sources:
1) involuntary default: owing to sheer misfortune (crop failure,
unemployment, disease, death, etc.), the borrower simply may not have
enough money when the loan matures.
2) voluntary or strategic default: the borrower may simply take the
money and run, or stubbornly refuse to pay up. In regions where the legal
machinery is not strong or functions slowly, such a possibility is not unlikely.

exogenous probability p of default on every dollar lent out. Let L be the total
amount of funds he lends out, let r be the opportunity cost of funds for every
moneylender, and let i be the interest rate charged in competitive equilibrium
in the informal sector. Because only a fraction p of loans will be repaid, the
moneylender’s expected profit is p(1 + i)L − (1 + r)L.
Competition between moneylenders drives the rural interest rate down to a
point where each lender on the average earns zero expected profit.
p(1 + i)L − (1 + r)L = 0
P = 1 => i = r: informal interest rates are the same as formal-sector rates.
However, for p < 1, we have i > r: the informal rate is higher to

In advanced economies with sophisticated credit systems, the risk of default is lower due to
strong legal enforcement and collateral requirements. However, in informal credit markets,
where such mechanisms are lacking, default risk is higher. It's surprising that in rural credit
markets, where there's less legal enforcement and collateral, default rates are often much
lower than in formal sectors with stricter rules and regulations.

Aleem's study revealed that in most cases he examined, the percentage of borrowers who
failed to repay their loans was less than 5%. This suggests that although there is a risk that
borrowers might not repay their loans, lenders are able to design agreements and provide
incentives that help reduce this risk. By understanding how lenders manage to lower the
chances of borrowers defaulting, we can gain insight into the specific characteristics of
informal credit markets.

14.3.3. Default and fixed-capital loans

In reality, larger loan amounts may increase the risk of default. This means that certain loans
may not be given at all, regardless of the interest rate offered, because the size of the loan
itself affects the likelihood of repayment. Additionally, loans used for purposes that could
potentially eliminate the need for future borrowing might also be less likely to be granted.
For example, if a rural worker wants to borrow money to move to the city and start a
business, it's unlikely that a rural lender would approve such a loan, as it could eliminate the
need for future borrowing. Consequently, informal loans are often provided for immediate
needs or short-term investments rather than long-term ventures that could reduce the need
for future credit.

14.3.4. Default and collateral

When borrowers might not repay loans, lenders often ask for collateral to secure their
investment. Collateral comes in various forms, such as land or labor rights, which borrowers
pledge until the loan is repaid. Sometimes, unconventional items like ration cards are used as
collateral. There are two types of collateral: one valued highly by both parties and another
valued mostly by the borrower. Regardless of type, collateral aims to discourage default. For
instance, a pawnbroker might accept a personal item, like a watch, as collateral, knowing its
sentimental value to the borrower, thereby encouraging loan repayment

See notebook.
14.3.5. Default and credit rationing
credit rationing refers to a situation in which at the going rate of interest in the
credit transaction, the borrower would like to borrow more money, but is not
permitted to by the lender.