Part 3|DF201|Question 5

A Clear understanding of the rural interest rate formation is at the heart of a successful rural credit and finance policy. Discuss.

Micro-Finiance Institutions/PDF Stiglitz/Weiss Model.

By “refusing” to charge higher interest rates (i.e. prices), which would in turn reduce the demand which exists at imax, the banks render the market mechanism ineffective: The existing excess demand for funds cannot be absorbed by increased prices, but instead remains at the level plotted on the graph.
Thus, it may be concluded that even without legal interest rate restrictions, information asymmetries can lead to “implicit” interest rate ceilings; this in turn prevents markets from clearing and leads to credit rationing.7
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The assumptions made by Stiglitz/Weiss which are problematic
in this respect are that
a) all borrowers demand credit in equal amounts,
b) all borrowers have the same expected RoI on their projects, and
c) transaction costs need not be taken into account.
...
The relevant best practice suggests that the Stiglitz-Weiss model overestimates the importance of adverse selection as a reason for credit rationing insofar as it is possible – albeit with a certain amount of effort – to resolve or alleviate this problem.
...
Items of collateral are, in the words of O.E.Williamson,11 hostages to support exchange and cooperation, and a rational collateral policy is one that is designed according to this principle.

Adverse selection

On the most abstract level, it refers to a market process in which bad results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers. Two ways to model adverse selection are with signaling games and screening games.

Moral hazard

In economic theory, the term moral hazard refers to the possibility that the redistribution of risk (such as insurance which transfers risk from the insured to the insurer) changes people's behaviour. For example, a person whose automobile is insured against theft may be less vigilant in locking the vehicle than an individual who is not insured.

References:
Bhaduri,A (1977) "On the Formation of Usurious Interest Rates in Backward Agriculture", reprinted from Coats and Khatkhate (1980)


Stiglitz