WMST 245 Development Finance



WMST 245 Finance Concepts

|Features |Directed Credit Paradigm |Financial Market Paradigm |

|Problem definition |Overcoming market imperfections |Reducing transaction costs |

|Role of financial markets |help the poor |Assist in allocating resources more |

| |boost technology |efficiently |

| |boost investment | |

| |implement plans | |

|View of users |Beneficiaries: borrowers |Clients: savers and borrowers |

|Subsidies & taxes |Lots of both via interest rates & loan |Few of either: subsidy independent |

| |recovery: subsidy dependent | |

|Sources of funds |Vertical: government & donors |Horizontal: mostly voluntary deposits |

|Associated information systems |Dense, fragmented, vertical: were targets |Less dense, mainly horizontal: information |

| |met? |for managers |

|Evaluations |Credit impact on borrowers: mainly primary |Performance of financial institutions: |

| |data |mainly secondary information |

Source: Robert C. Vogel and Dale W. Adams (April 1996), “Old and New Paradigms in Development Finance,” (Draft Paper).

Finance Words

Adverse Selection: People who buy insurance often have a better idea of the risks they face than do the sellers of insurance. People who know they face large risks are more likely to buy insurance than people who face small risks; this is adverse selection. Insurance companies prefer a mix of small and bigger risks. To achieve this, life insurance companies require medical examinations and refuse policies to people who have terminal illnesses, and automobile insurance companies charge much more to people with convictions for drunk driving.

Moral Hazard: Because insurance changes the costs of misfortune, insurance can change people’s behavior. They may make less effort to avoid misfortune; this is moral hazard. For example, if an accident costs a person $1,000 but insurance pays $800, the insured person has an incentive to avoid the accident. If the accident costs the person $1,000 but insurance pays $2,000, the person not only has no incentive to avoid the accident but may have an incentive to seek it out. Sometimes moral hazard is dramatic. Fire insurance encourages arson, automobile insurance encourages accidents, and disability insurance may encourage carelessness on the job.

Covariant Risk: Earthquakes, floods, hurricanes or windstorms often impact whole regions and thus will affect all policyholders in one region: there is a covariant risk. In farming areas, if a drought causes crop failure, it is likely every farmer’s crops will fail at the same time. For insurance companies underwriting a large number of claims in one region, or banks lending to farmers, this means that their risk portfolio is highly correlated, and they may be unwilling to provide financial services in the region, or may charge very high prices for the services.

Real Interest Rate: If there is inflation, money borrowed is worth less when it is repaid, and the real interest rate is the nominal interest rate minus the rate of inflation.

Access

Adverse selection

Arrears

Bankability

Capitalization

Collateral

Consumption smoothing

Covariant risk

Credit as “input”?

Default rates

Directed credit

Equity requirements

Financial and non-financial costs

Formal and informal finance

Fungibility

Group guarantees

Information costs

Instruments

Intermediation

Joint liability

Linked transactions

Liquidity

Loan quality

Loan shark

Loanable funds

Mobile banking

Monetary or financial deepening

Monetization

Monopolistic competition

Monopoly

Moral hazard

Non-performing assets

Paradigm

Peer pressure

Perfect competition

Prudential mechanisms

Portfolio quality

Real interest rate

Remittance

Reserve requirements

Rotating savings and credit associations (ROSCAs)

Savings mobilization

Spreads

Supervision

Sustainability

Transaction costs

Working capital

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