Credit Markets and Risk Management in Low-Income Economies

Posted on May 17, 2024 in Economy

Credit Markets | Asset Transfer

Provide context-sensitive assets (cattle, tools, equipment, irrigations) that will allow long-term income generation.

Human Capital

Provide training in:

• Use of assets
• Business skills
• Financial literacy

Social Protection

Provide insurance to strengthen resilience and allow households to recover from shocks (offset effect of high-risk aversion).

• Formal Insurance
• Savings
• Income Transfer

Coaching

Provide training on soft skills and psychological assets (lower people’s discount rate).

• Budgeting, organization, and planning for the future
• Empowerment and identity

Credit: Three Crucial Roles

Credit allows you to get ahead

• Directly allows investments to raise expected income

Credit prevents you from falling behind

• Credit for consumption after a shock
• Indirectly promotes investments via “credit as insurance”

Credit shifts risk

• Default clause and liability rules define circumstances when the borrower does not have to fully repay.
• This shifts some risk from borrowers to lenders (who are more able to accept it). Can thus induce people to make high-return, but risky investments that they otherwise would not make.

Credit Used as Insurance: Credit for Consumption After a Shock

• Severe drought caused complete loss of 2016 harvest.
• Reduced meals from 3 to 2 per day for 4 months.
• Pulled 2 kids from school… leading to repeat grades.
• Access to credit after drought would have been a life changer. If they had been able to borrow, they would not have had to take these decisions that can have negative, long-term effects.

Credit Indirectly Promotes Investments via “Credit as Insurance” (Ex-Ante Effect)

• Ana and Zimba plant local maize instead of hybrid maize because they are afraid they will have nothing (even less than above) if the harvest fails.
• Access to credit after the drought might have made them willing to plant more profitable, but riskier hybrid variants.

Credit Can Shift Risk

Limited liability credit contracts:

• When the borrower does not have to fully repay, if the crop fails, for example.
• Leads to shifts in risk from borrowers to lenders.
• Have higher return, but riskier investments that they otherwise would not make.

Limited Liability

Why do we need to consider limited liability credit contracts, especially in low-income areas of poorer countries?

• Farms & Businesses face lots of risk.
• Poor farmers and businesses often don’t have collateral.
• This is not necessarily a problem for lenders.
• If the lender has a good idea of how risky a borrower is, she can adjust the interest rate.
• Charge risky borrowers high-interest rates to compensate for the higher probability that the loan will default.

Measuring Financial Inclusion

The World Bank sends out surveys to ask what financial markets households are in.

Asymmetric Information

One party to a transaction has greater information about the quality of the goods and services being transacted than the other. AI can lead to equilibrium that is not efficient.

Credit Rationing

Excess demands when the price drops below the equilibrium crossing point.

Liability Rules

Unlimited: the borrower must fully repay the loan.

Limited: Does not have to fully repay the loan.

Roles of Interest

Role 1: If lenders had symmetric information and could force individuals to borrow, then higher interest rates lead to higher lender profits. When there are multiple types of borrowers, the lender would earn:

• E(piS) = -10 + 100i (on a loan to a safe type if safe type borrows)
• E(piR) = -60 + 50i (on a loan to a risky type if risky type borrows)

Role 2: In practice, lenders do not have all the information and cannot force individuals to borrow, so the interest will also serve as a mechanism to indirectly control the actions of borrowers.

Adverse Selection

The lender cannot distinguish the Safe type from Risky types, but she can adjust the interest rate to control which types end up borrowing.

Moral Hazard

The lender cannot force the borrower to choose a safe versus risky project, but she can adjust the interest rate to control which project the borrower ends up doing.

Profit Curve

FIND DATA ON LOW-INTEREST RATES – SUMMARY OF ADVERSE SELECTION

Equilibrium: Adverse Selection: Under Perfect Competition

• Lenders will pick i that makes borrowers as best off as possible while allowing them to earn E(pi) >= 0.
• This occurs at the lowest i such that E(pi) = 0.

Setup: The Borrower

Only 1 type of borrower: Yaxi’s Ramen Shop

2 possible actions (techniques)

Technique 1: Serve traditional Tonkotsu (Pork) Ramen

• Invest $120
• Generate $200 in revenues with certainty (no risk)

Technique 2: Serve unconventional Picaduro (Japanese fire pepper) Ramen

• Invest $120
• 50% of the time successful, earning $240 in revenue
• 50% of the time failure, earning $0 revenue

Yaxi’s expected income depends on the technique she chooses:

• E(Y1) = 1[200-(1+i)120] = 80 – 120i
• E(y2) = .2[240-(1+i)120] + .5=0-0*(1+i)120] = 60-100i

Indirect Mechanisms

Contractual terms that provide incentives to loan applicants and borrowers in a way that reduces

• By controlling interest rates, lenders can account for adverse selection and moral hazard.

Loan Size #2

Basic Idea “Offer a carrot”

• Start out offering a small loan.
• If repaid, offer larger and larger loans.

Addresses adverse selection:

• The lender can identify really bad types as those who default on the first loan.
• The cost of identifying bad types is low because the loan size is small.

Addresses Moral Hazard:

• The promise of larger future loans provides incentives for the borrower to behave well (repay).

Threat of Termination

If the borrower defaults, deny future access to loans.

Addresses MH: Again, provides incentives to behave well.

Problems: Can lenders prevent defaulters from getting loans?

Collateral

Assets that the borrower loses to the bank if the borrower defaults. Lenders can liquidate (sell) the assets to recover the loan repayment.

What Types of Assets Make Good Collateral?

Valuable to the borrower (very important) and to the lender (not as important).

What are desirable characteristics?

• Immobile (or really small… so the lender can hold it)
• Quality (value is not subject to moral hazard)
• Property rights are well defined and easily transferable

Limitations to collateral in rural areas of LDC’s

• Poor people don’t have many assets.
• The ones they do have may not be acceptable to banks (What assets do the poor own?).
• Transaction costs of posting collateral are high – In practice, the last thing the bank wants to do is foreclose on somebody.

Direct Mechanisms

Screening: Gather information about borrower type before approving the loan.

Monitoring: Gather information about the borrower’s actions after giving the loan.

Expected Utility Framework

Effect of risk on people and their decisions.

EU(C)

E: Expected Value, U: Utility Function

• Tell us how happy we are.
• Function of consumption.
• U(10) is the utility of consuming $10 worth of stuff.
• U(.) can take many shapes, but we always assume utility increases when C increases.

So EU(C) is: Expected value of the utility of consumption.

• Just the expected utility of consumption. How happy will I be on average if I do a risky activity?

Certainty Equivalent: Guaranteed return that someone would be willing to take now.

Equation: U(W+CE) = EU(W+y)

• W is wealth, Y is income, Random variable.
• Beginning of the year, we don’t know what income will be.
• We know probabilities.
• W + y = consumption. I buy consumption with wealth plus income.
• EU(W+y): How happy I’ll be on average, if I keep the risky project.
• U(W+CE): How happy I’ll be if I sell the project and receive a guaranteed income equal to CE.

Risk Premium

Amount of money someone is willing to pay in order to eliminate the risk associated with the activity and instead receive the expected value of that activity’s income with certainty. P is implicitly defined by the following equation, U(W+E(y)-p) = EU(W + y).

• Left shows happiness with consuming with certainty.
• Right shows: Happiness from keeping and doing the project.

Risk Preference

An individual is risk-averse if, for a risky activity:

• CE < E(y), P>0; Since (P = E(y) – CE)
• They have a positive willingness to pay to eliminate risk.

Risk Neutral

• CE = E(y), P = 0

Risk Loving

• CE > E(y), P < 0
• Negative willingness to pay to eliminate their risk (they are willing to pay to take on more risk).

Insurance Contract Math

With Insurance C = W + Y – Insurance Premium + Indemnity

Informal Risk Sharing Arrangements

• Similar to Microfinance
• Local people (family, friends, villagers) have good information about each other’s:
• Types, Actions
• Thus they may be able to insure each other.
• T – is the transfer an individual pays into the village pot, T > 0 means I put money into the pot; T < 0 means I withdraw money out of the pot.

In order for the IRSA to be feasible, we need the expected value of T to be zero or positive.

• E(T) = 0 – It’s feasible. The same amount going into the pot as coming out.

C = W + E(y) The transfer will allow individuals to perfectly smooth consumption at a level equal to their wealth plus the expected value of income.

Feasibility

• E(T) = 0 is feasible. The same amount of money goes in and the same amount of money goes out.

Credit Markets

• First Generation
• Second Generation

Risk and Willingness to Invest

• Relative profitability
• Relative riskiness
• Risk Preference
• Ability to manage risk

Income Versus Consumption Risk

• Most people are risk-averse. They prefer certain, steady consumption to consumption that is variable/fluctuating.
• What can people do to reduce the risk/variability in consumption?
• Consumption Smoothing: the ways by which individuals or households convert a variable income stream into a less variable consumption stream.
• This is an ex-post concept: How do individuals maintain relatively constant consumption after they experience a good or bad shock to their income.
• Income Smoothing: ex-ante e.g. choose at the beginning of the year.

How to Income and Consumption Smooth

Consumption:

• If you have a really good year, you are not consuming all of it. You could contribute some to the village pot, put some money in the bank, purchase more livestock. If you have a bad year vice versa.
• Consumption movers would be easier for poor people compared to rich.
• Borrowing money, information risk-sharing arrangements, buying insurance.

Risk & Wealth

• Rich people are more willing to bear risk.
• Wealthier people have a lower risk premium than poor people.
• Decreasing absolute risk aversion.
• Wealthy people are more able to manage risk.
• Credit & insurance markets tend to work better for wealthy than poor people.
• For both reasons, the wealthy are more likely to do high-risk high-return activities.
• Poor maybe stuck in poverty traps.
• Wealth inequalities reinforced and widened over time.

Risk and Poverty Traps

Ex-Post consequences of price & yield shocks

• Reduced consumption
• Decapitalization
• Sell-off productive assets (land, equipment, animals)
• Reduction in human capital (nutrition, education)

Critical Roles of Crop Insurance

Ex-Post: Allows farmers to maintain consumption levels and avoid selling off assets after a shock.

Forms of insurance

Information Risk Sharing Arrangements

• Social network, neighborhood get together to insure each other. Potting money.
• People that have a good year help those who had a bad.
• Does not help when everyone is affected by poor growing conditions.

Conventional Crop Insurance

• Farmers pay a premium. Insurance adjuster comes out and pays out depending on if damages meet criteria.
• Asymmetric Information:
• Moral Hazard: Losses may be due to farmer’s actions or practices.
• Adverse Selection: the highest risk farmers are most likely to buy insurance.

Index Insurance

• Farmer’s field assigned to the nearest government meteorological station.
• If cumulative rainfall at the stations < 500 mm during the season, the insurance company makes payouts.
• Payout depends on an external index.
• No need for asymmetric information problems.
• Avoids moral hazard and adverse selection.
• Satellite-based data significantly increase the range of potential indices.
• Minimal transaction cost.
• Does not cover all things that could go wrong on a farm.

Impact Evaluation

Impact Evaluation is a type of research program that generates quantitative estimates of the causal impact of a treatment.

• The primary goal is to provide a good (unbiased) estimate of the Average Treatment Effect.
• ATE = [Average outcome of treatment group] – [Average outcome of treatment group if they had not been treated]
• ATENaive = [Average outcome of treatment group] – [Average outcome of control group]
• A good control group is when [avg outcome of control group] = [avg outcome of treatment group if they had not been treated]

Selection Bias: SB = ATENaive – ATE

, SB tell us if the ATENaive is good., SB = 0(zero selection bias), ATENaive = ATE, The ATENaive gives us an accurate estimate of the ATE , SB > 0 (positive selection bias), ATENaive > ATE, The ATENaive will over-state the ATE, We incorrectly conclude that the impact is larger than it truly is SB > 0, ATENaive