average probability of repayment over the whole group of borrowers, multiplied by the interest rate that they have to pay, must equal the opportunity cost
of funds to the lender. Each borrower thus cares about the average repayment
rate among the other borrowers because that rate affects the interest rate that
he or she is charged. But an individual who is deciding whether or not to apply
for a loan may ignore the fact that doing so affects the well-being of the other
borrowers-which generates an externality as described above.
Situations of adverse selection give a lender an incentive to find ways to separate borrowers into different groups according to their likelihood of repayment. One device for screening out poor-quality borrowers is to use a collateral
requirement (Stiglitz and Weiss 1986). If the lender demands that each borrower put up some collateral, the high-risk borrowers will be least inclined to comply because they are most likely to lose the collateral if their project fails. Given
the scarcity of collateral and the difficulty of foreclosure discussed earlier, sorting out high-risk borrowers is certainly difficult and may be impossible. The
discussion that follows therefore assumes that the lender is unable to distinguish between those borrowers who are likely to repay and those who are not.
The Stiglitz-Weiss model (1981) of the credit markets seems relevant for
thinking about formal lending in a rural context, where it is reasonable to suppose that banks will not have as much information as their borrowers. The
model also appears to yield an unambiguous policy conclusion that lending
will be too low from a social point of view. In fact, it can be shown that a
government policy that expands lending-through subsidies, for exampleraises welfare in this model by offsetting the negative externality that bad borrowers create for good ones and by encouraging some of the better borrowers
to borrow. In other words, adverse selection examined in the context of Stiglitz
and Weiss's model argues for government intervention on the grounds of an
explicit account of market failure.
How robust is their conclusion? DeMeza and Webb (1987) enter a caveat:
instead of supposing that projects have the same mean, they suppose that
projects differ in their expected profitability, with good projects more likely to
yield a good return. They also suppose, as do Stiglitz and Weiss, that the lender
does not have access to the private information that individuals have about the
projects they are able to undertake. At any given interest rate, set to break even
at the average quality of project funded, DeMeza and Webb show that some
projects with a negative social return will be financed. Thus the competitive
equilibrium has socially excessive investment levels. A corollary developed by
DeMeza and Webb is that government interventions-such as a tax on investment-to restrict the level of lending to a competitive equilibrium are worth-while.
Thus, both the Stiglitz-Weiss and DeMeza-Webb analyses conclude that the
level of investment will be inefficient, but they recommend opposite policy interventions as a solution. The conflicting recommendations would not be especially disquieting except that the differences between the models are not based upon things that can be measured with precision, but on assumptions
about the project technology: for example, whether the mean return of the
project is held fixed. So it is hard to know which of the results would apply in
practice
average probability of repayment over the whole group of borrowers, multiplied by the interest rate that they have to pay, must equal the opportunity costof funds to the lender. Each borrower thus cares about the average repaymentrate among the other borrowers because that rate affects the interest rate thathe or she is charged. But an individual who is deciding whether or not to applyfor a loan may ignore the fact that doing so affects the well-being of the otherborrowers-which generates an externality as described above.Situations of adverse selection give a lender an incentive to find ways to separate borrowers into different groups according to their likelihood of repayment. One device for screening out poor-quality borrowers is to use a collateralrequirement (Stiglitz and Weiss 1986). If the lender demands that each borrower put up some collateral, the high-risk borrowers will be least inclined to comply because they are most likely to lose the collateral if their project fails. Giventhe scarcity of collateral and the difficulty of foreclosure discussed earlier, sorting out high-risk borrowers is certainly difficult and may be impossible. Thediscussion that follows therefore assumes that the lender is unable to distinguish between those borrowers who are likely to repay and those who are not.The Stiglitz-Weiss model (1981) of the credit markets seems relevant forthinking about formal lending in a rural context, where it is reasonable to suppose that banks will not have as much information as their borrowers. Themodel also appears to yield an unambiguous policy conclusion that lendingwill be too low from a social point of view. In fact, it can be shown that agovernment policy that expands lending-through subsidies, for exampleraises welfare in this model by offsetting the negative externality that bad borrowers create for good ones and by encouraging some of the better borrowersto borrow. In other words, adverse selection examined in the context of Stiglitzand Weiss's model argues for government intervention on the grounds of anexplicit account of market failure.How robust is their conclusion? DeMeza and Webb (1987) enter a caveat:instead of supposing that projects have the same mean, they suppose thatprojects differ in their expected profitability, with good projects more likely toyield a good return. They also suppose, as do Stiglitz and Weiss, that the lenderdoes not have access to the private information that individuals have about theprojects they are able to undertake. At any given interest rate, set to break evenat the average quality of project funded, DeMeza and Webb show that someprojects with a negative social return will be financed. Thus the competitiveequilibrium has socially excessive investment levels. A corollary developed byDeMeza and Webb is that government interventions-such as a tax on investment-to restrict the level of lending to a competitive equilibrium are worth-while.Thus, both the Stiglitz-Weiss and DeMeza-Webb analyses conclude that thelevel of investment will be inefficient, but they recommend opposite policy interventions as a solution. The conflicting recommendations would not be especially disquieting except that the differences between the models are not based upon things that can be measured with precision, but on assumptionsabout the project technology: for example, whether the mean return of theproject is held fixed. So it is hard to know which of the results would apply inpractice
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