Tuesday, September 11, 2007

Part 2|DF201|Question 5

4 The Determination of Rural Interest Rates
The four components of interest rates specified by Bottomley are:
1. the opportunity cost of capital (cyclical nature of loans)
2. the administration premium
3. the risk premium
4. monopoly profit (are there barriers to entry-ie no other capital is available?)

The summary of costs of Moneylender and Urban Banks costs.
1. Basic rate is 15% for ML-I assume that the opportunity costs are quite high vs. liquid banks that can obtain other revenues to have 5% opportunity costs. Also as noted above that seasonal nature of the ML then his capital may be idle for longer periods.
2. Administrative costs start are 1/2 what it is for Urban for all loan sizes.
3. Default is highly in favor of ML at low size loans but approaching 1000 it goes to Urban Banks.
4. Overall risk premium is much lower at smaller loan sizes for ML but goes to Urban at higher size loans. Urban banks do get to Average Risk as compared to ML that may not be able to diversify risk as easily.

Risk Premium= (assumed default rate*(principle + lending costs)/principal actually repaid

Causes of Default:
1. Loan size: the more a man borrows, the larger will be the probability of his being unable to repay. I am not sure nominal size matters, loan size to net worth. But some of the other factors are listed below.
2. Borrower net income: there will often be a positive relationship between net income and levels of payment but the correlation is not always as great as one might expect.
3. Debt-equity ratio.
4. Value of collateral.
5. Defaulters brought to court. Lack of an adequate legal system of property rights.
6. Income variance. Thus an inelastic demand curve based on consumption needs instead of basic investments.
7. Administrative costs of collection.
8. Real rate of interest. If negative-subsidization then defaults should be low since why bite the hand that feeds you (free gifts). Which is a wealth transfer.
9. Type of lender. The closer the relationship from lender to borrower is the more likely to repay, for example Cooperatives before urban banks.

It is also important to understand that even if borrowers have the ability to repay there may also be the factor of willingness to pay as we saw above.

References:
Bottomley, Anthony (1975) "Interest Rate Determination in Underdeveloped Rural Areas", Reprinted in Von Pischke (1983)

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