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Capital Accumulation in the Presence of Informal Credit Contract: Does Incentive Mechanism Work Better than Credit Rationing Under Asymmetric Information?

  • basab dasgupta

    ()

    (economics university of connecticut)

Credit markets with asymmetric information often prefer credit rationing as a profit maximizing device. This paper asks whether the presence of informal credit markets reduces the cost of credit rationing, that is, whether it can alleviate the impact of asymmetric information based on the available information. We used a dynamic general equilibrium model with heterogenous agents to assess this. Using Indian credit market data our study shows that the presence of informal credit market can reduce the cost of credit rationing by separating high risk firms from the low risk firms in the informal market. But even after this improvement, the steady state capital accumulation is still much lower as compared to incentive based market clearing rates. Through self revelation of each firm's type, based on the incentive mechanism, banks can diversify their risk by achieving a separating equilibrium in the loan market. Incentive mechanism helps banks to increase capital accumulation in the long run by charging lower rates and lending relatively higher amount to the less risky firms. Another important finding of this study is that self revelation leads to very significant welfare improvement, as measured by consumption equivalence

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 366.

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Date of creation: 11 Nov 2005
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Handle: RePEc:sce:scecf5:366
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  1. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
  2. Stephen D. Williamson, 1984. "Costly Monitoring, Loan Contracts and Equilibrium Credit Rationing," Working Papers 572, Queen's University, Department of Economics.
  3. Roger B. Myerson, 1977. "Incentive Compatability and the Bargaining Problem," Discussion Papers 284, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Williamson, Stephen D, 1987. "Financial Intermediation, Business Failures, and Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 95(6), pages 1196-1216, December.
  5. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
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  8. Levine, Ross & Zervos, Sara, 1996. "Stock market development and long-run growth," Policy Research Working Paper Series 1582, The World Bank.
  9. Jeremy C. Stein, 1998. "An Adverse-Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy," RAND Journal of Economics, The RAND Corporation, vol. 29(3), pages 466-486, Autumn.
  10. Bell, Clive, 1990. "Interactions between Institutional and Informal Credit Agencies in Rural India," World Bank Economic Review, World Bank Group, vol. 4(3), pages 297-327, September.
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  13. Robert Townsend & Rolf Mueller, 1998. "Mechanism Design and Village Economies: From Credit, to Tenancy, to Cropping Groups," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(1), pages 119-172, January.
  14. de Meza, David & Webb, David C, 1987. "Too Much Investment: A Problem of Asymmetric Information," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 281-92, May.
  15. Besanko, David & Thakor, Anjan V, 1987. "Collateral and Rationing: Sorting Equilibria in Monopolistic and Competitive Credit Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 671-89, October.
  16. Bose, Niloy & Cothren, Richard, 1997. "Asymmetric Information and Loan Contracts in a Neoclassical Growth Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 423-39, November.
  17. King, Robert G. & Levine, Ross, 1993. "Finance, entrepreneurship and growth: Theory and evidence," Journal of Monetary Economics, Elsevier, vol. 32(3), pages 513-542, December.
  18. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 75(4), pages 850-55, September.
  19. Floro, Maria Sagrario & Ray, Debraj, 1997. "Vertical Links between Formal and Informal Financial Institutions," Review of Development Economics, Wiley Blackwell, vol. 1(1), pages 34-56, February.
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