How Do Market Failures Justify Interventions in Rural ...

[Pages:37]How Do Market Failures Justify Interventions in Rural Credit Markets? Author(s): Timothy Besley Source: The World Bank Research Observer, Vol. 9, No. 1 (Jan., 1994), pp. 27-47 Published by: Oxford University Press Stable URL: Accessed: 01/11/2010 12:23 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at . JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at . Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@.

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HOW DO MARKET FAILURES JUSTIFY INTERVENTIONS IN RURAL CREDIT MARKETS?

Timothy Besley

Understanding of the economic causes and consequences of market failure in credit markets has progresseda great deal in recentyears. This article draws on

these developments to appraisethe case for government interventionin ruralfi-

nancial markets in developing countries and to discover whether the theoretical findings can be used to identify directivesfor policy.

Before debating the when and how of intervention,the article definesmarket failure, emphasizingthe needto considerthefull arrayof constraintsthatcombine to makea marketwork imperfectly.The variousreasonsfor marketfailurearediscussed and set in the context in which creditmarketsfunction in developingcountries. The articlethen looks at recurrentproblemsthat may be cited as failuresof the marketjustifyingintervention.Among theseproblemsareenforcement;imperfect information, especiallyadverseselection and moral hazard;the risk of bank runs; and the need for safeguardsagainst the monopoly power of some lenders. The review concludeswith a discussionof interventions,focusing on the learning process that must take placefor financialmarketsto operateeffectively.

Interventionsin ruralcreditmarketsin developingcountries are common

and take many differentforms. Chief among them is governmentownership of banks; India and Mexico, for example, nationalized their major banks in 1969 and 1982, respectively. In these cases the government can compel its banks to set up branches in rural areas and to lend to farmers. Governments in other countries, such as Nigeria, have imposed a similar obligation on commercial banks (see Okorie 1990). So the presence of a bank in a particulararea is not sufficient reason to assume that the bank has chosen to operate there or that it is operating profitably.

Regulations have also affected the day-to-day operation of banking. Straightforward subsidization of credit is a standard policy in many countries;

The World Bank Research Observer, vol. 9, no. 1 (January 1994), pp. 27-47

i) 1994 The InternationalBank for Reconstruction and Development/THEWORLDBANK

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one exampleis the systemestablishedby the governmentof the Philippinesin which low-interestloans are financedby a low interestratepaid on deposits (WorldBank1987).Chargingbelow-marketinterestratesgeneratesexcessde-

mandfor credit,andas a resultbankoperationshaveoften beengovernedby rulesfor the selectiveallocationof credit;the Masagna-99programthat targetedricefarmersin thePhilippinesis a casein point.Moregenerally,Filipino bankswererequiredto allocate25 percentof all loansto the agriculturaslector, and the governmenthas also limitedtheirflexibilityto set interestrates and lend accordingto privateprofitabilityF. oreignandprivatebanksin India havealso facedrestrictionson the extentof theirlendingactivity(India,Governmentof 1991).

Variousgovernmentshavealso requiredthatlendersinsuretheirloan portfolios. The apexagriculturabl ankin Indiahas insuredloansin agriculturefor amountsup to 75 percentof outstandingoverdues.Similarpolicieswerepursued in Mexico, wherethe principalagriculturalenderhas had its loan portfolio compulsorilyinsuredby a government-ownedinsurer.Becausedefault rateson ruralloansaretypicallyquitehigh,suchschemesalso providean explicit subsidyto ruralfinancialinstitutions.

Thus, it seemsfair to say that ruralcreditmarketsin developingcountries haverarelyoperatedon a commercialbasis.Substantiaslubsidiesareoftenimplicit in the regulationschemes.A traditionalview would see these interventionsas partandparcelof developmentpolicythroughoutmuchof thepostwar era:an activelyinterventionisgtovernmentcontrollingthecommandingheights of the economyand takingthe lead in openingup new sectors.

It is widelyrecognizedthatsuchpolicies,particularlybelow-markeitnterest ratesand selectiveallocationof credit,are not withoutcost. One view, associatedwith McKinnon(1973),is thatthesepoliciesleadto financialrepression: withouta marketallocationmechanism,savingsand-creditwill be misallocated. Thus, it becamepopularto arguefor financialiberalizationandrelaxation of governmentregulationse, speciallythosethatheldinterestrateson loansbelow market-clearinlgevels.

This type of interventionwas also criticizedby the Ohio StateUniversity groupon the groundsthat manyof the policieswerenot consistentwith such objectivesas helpingthe poor (see, for example,Adams,Graham,and Von Pischke1984).The grouppointedto two centralfacetsof manygovernmentbackedloan programsf:irst,defaultratesweretypicallyveryhigh,and, second, muchof the benefitof theseprogramsappearedto go to the wealthierfarmers.

Criticismof existingpolicieshas led to considerablerethinkingaboutinterventionin ruralcreditmarketsin developingcountries.In particulart,he view has gainedgroundthatinterventionshouldbe restrictedto caseswherea market failurehas beenidentified;this view is investigatedhere.The objectiveis to considerwhetherand how interventionscan be-or are being-used to make up for shortcomingsof existing (formaland informal)marketsto allocate credit.

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What Are MarketFailures?

A market failure occurs when a competitive market fails to bring about an efficient allocation of credit. Credit, like other goods, has supply and demand. Some individuals must be willing to postpone some consumption so that others can either consume (with a consumption loan) or invest (with an investment loan). The price of credit-the interest rate at which a loan is granted-must therefore be high enough for some individuals to postpone their consumption and low-enough for individualswho take out loans to be willing to repay, given their current consumption needs or investment opportunities.

In an idealized credit market, loans are traded competitively and the interest rate is determined through supply and demand. Because individuals with the best investment opportunities are willing to pay the highest interest rates, the best investment opportunities should theoretically be selected. Such a loan market would be efficient, in the standard economic sense of Paretoefficiency; that is, the market is efficient when it is not possible to make someone better off without making someone else worse off (no Pareto improvement is possible). Allowing two individuals to trade typically generates such an improvement. If one has an investment opportunity and no capital, for example, and the other has some capital, both may gain by having the second individuallend to the first. They need only to find some way to share the gains from their trade for both to benefit. Both must be at least equally well off with the trade for them to participate in it voluntarily.

An outcome is thus Pareto efficient when all Pareto improvements are exhausted-which happens for credit when the loans cannot be reallocated to make one individual better off without making another worse off. In particular, Pareto efficiency is achieved when an individual who gets a loan has no incentive to resell it to another and become a lender himself.

The first fundamental welfare theorem says that competitive markets with no externalities yield a Pareto-efficient outcome. But the standard model of perfect competition, where large numbers of buyers and sellers engage in trade without transactions costs, has some deficiencies as a model for credit markets, both in theory and in practice. The waters are muddied in credit markets by the issue of repayment, because a debtor may be unable to repay (for instance, if he is hit by a shock such as bad weather or a fire), or unwilling to repay (if the lender has insufficient sanctions against delinquent borrowers). For the latter contingency, credit markets require a framework of legal enforcement. But if the costs of enforcement are too high, a lender may simply cease to lenda situation that may well arise for poor farmers in developing countries.

Credit marketsalso diverge from an idealized market because informationis imperfect. A lender's willingness to lend money to a particularborrower may hinge on having enough informationabout the borrower'sreliabilityand on being sure that the borrower will use the borrowed funds wisely. The absence of good informationmay explainwhy lenderschoose not to servesome individuals.

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Efficiencyin the allocationof credithas to be examinedin light of these practicalrealities.Suppose,for example,that a bankis consideringproviding creditfor a projectto someonewho, afterreceivingthe loan,will choosehow hardto work to makehis projectsuccessful.If the projectis successful,then the loan is repaid,but, if it fails, the individualis assumedto default.As the size of the loan increases,the borrower'seffortis likelyto slacken,becausea largershareof the proceedsof the projectgo to the bank.If the bankcannot monitorthe borrower'sactions(perhapsbecausedoingso is prohibitivelycostly), a biggerloantendsto be associatedwith a lowerprobabilityof repayment. A bankthatwantsto maximizeprofitsis thereforelikelyto offera smallerloan than it would if monitoringwerecostless.This may resultin less investment in the economyand, in comparisonwith a situationin whichinformationis costless,would appearto entail a reductionin efficiency.With full information, the bank shouldbe willingto lend more, to the advantageof both the borrowerand the lender.Thus,testedagainstthe benchmarkof costlessmonitoring,thereappearsto be a marketfailure- that is, the markethas not realized a potentialParetoimprovement.

But in the real world monitoringis not costless and informationand enforcementarenot perfect.A standardof efficiencyimpossibleto achievein the realworld is not a usefultest againstwhichto definemarketfailure.The test of efficiencyshould still be that a Paretoimprovementis impossibleto find, butsuchan improvemenmt ustbe soughttakinginto accounttheimperfections of informationandenforcementhatthe marketin questionhasto dealwiththat is usingthe conceptof constrainedParetoefficiency.Bythis standard,the outcomedescribedabove,wherethe lenderreducedthe amountlentto a borrower becauseof monitoringdifficulties,could in fact be efficientin a constrainedsense. The informationproblemmay still have an efficiencycost to society,but froman operationalpoint of view that cost has no relevance.

The argumentthatproblemsin creditmarketsresultin a lowerlevelof output, and perhapstoo muchrisk-takingrelativeto some idealsituationwhere informationis freelyavailable,is frequentlyusedto justifysubsidizedcreditor the establishmentof government-ownebdanksin areasthatappearto be poorly servedby the publicsector.This argumentis a non sequiturand shouldbe resisted wheneverencountered.In thinking about marketfailure and constrainedParetoefficiency,thefull set of feasibilityconstraintsfor allocatingresourcesneedsto be consideredI. n this article,marketfailureis takento mean the inabilityof a freemarketto bringabouta constrainedPareto-efficienatllocationof credit,in the sensedefinedabove (seeDixit 1987for a sampleformalanalysis).The restof the articleexaminesthe implicationsof thisconcept.

Applyingthe criterionof constrainedParetoefficiencynarrowsthe fieldfor marketfailure,butit stillleavesroomfor a fairlybroadarrayof casesin which resourcescouldendup beinginefficientlyallocated.Intheillustrationof Pareto improvementused above,only the well-beingof the two individualsinvolved in a trade was considered.But if externalitiesenter the picture in other

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words, if a thirdpartyis affected,possiblynegatively,by the decisionof the other two-a Paretoimprovemenits clearlynot guaranteed,even if the two principalsare madebetteroff. It is well known that marketsoperateinefficientlyif thereareexternalities(seeGreenwaldand Stiglitz1986for a general discussion),and specifictypes of externalitiesmay particularlyafflictcredit markets.One importantroleforgovernmentpolicyto improvetheworkingof creditmarketsis to deal impartiallywith externalityproblems.

SignificantFeaturesof RuralCreditMarkets

Whatmakesruralcreditmarketsin developingcountriesdifferentfromother creditmarkets?The threeprincipalfeaturesdistinguishedhere-collateral security, underdevelopmenitn complementaryinstitutions, and covariant risks-characterizeall creditmarketsto someextent. The distinctionis in degree ratherthan in kind;theseproblemsare felt muchmoreacutelyin rural credit markets,and in developingcountries,than in other contextsin which creditmarketsoperate.That is why those governmentshaveregardedpolicy initiativesin this areaas important.

Scarce Collateral

One solutionto the repaymenpt roblemin creditmarketsis to havetheborrowerput up a physicalassetthatthe lendercan seizeif the borrowerdefaults. Suchassetsareusuallyhardto comeby in ruralcreditmarkets,partlybecause the borrowersare too poor to have assets that could be collateralizeda, nd partlybecausepoorlydevelopedpropertyrightsmakeappropriatingcollateral in the event of defaultdifficultin ruralareasof manydevelopingcountries. Improvingthe codificationof landrightsis oftensuggested,thereforea, s a way to extendthe domainof collateraland improvethe workingof financialmarkets. This idea is discussedin greaterdetailbelow.

Underdeveloped ComplementaryInstitutions

Creditmarketsin ruralareasof developingcountriesalso lack manyfeaturesthat aretakenfor grantedin most industrialcountries.Oneobviousexampleis a literateandnumeratepopulation.Poorlydevelopedcommunications in some ruralareasmayalso makethe useof formalbankarrangementcsostly for many individuals.In addition,complementarymarketsmay be missing. The virtualabsenceof insurancemarketsto mitigatethe problemsof income uncertaintyis a typicalexample.If individualscould insuretheirincomes,default mightbe less of a problem.Anotherway to mitigatedefaultproblemsis to assembleindividualcredithistoriesand to sanctiondelinquentborrowers. Suchmeansof enforcingrepaymenat recommonplacein moredevelopedecon-

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omies,but theyrequirereliablesystemsof communicationamonglendersthat seldomexist in ruralareasof developingcountries.

Deficienciesin complementariynstitutionsare mostlyancillaryto the credit marketand suggestpolicyinterventionosf theirown. Programsthat raiseliteracy levelsmay improvethe operationof creditmarketsyet could be justified withoutreferenceto the creditmarket.The benefitsto creditmarketsshould, theoreticallyf,igurein cost-benefiat nalysesof suchinterventionsb,utin practice it mightbetoo difficulto quantifythevalueof thosebenefitswithanyprecision.

Covariant Risk and SegmentedMarkets

A specialfeatureof agriculturew, hich providesthe incomeof most rural residents,is the riskof incomeshocks.Theseincludeweatherfluctuationsthat affectwhole regionsas well as changesin commoditypricesthat affectall the producersof a particularcommodity.Suchshocksaffecttheoperationof credit marketsif they createthe potentialfor a group of farmersto defaultat the sametime. The problemis exacerbatedif all depositorssimultaneouslytry to withdrawtheir savingsfrom the bank. This risk could be avertedif lenders heldloanportfoliosthatwerewell diversifiedB. utcreditmarketsin ruralareas tendto be segmented,meaningthata lender'sportfolioof loansis concentrated on a groupof individualsfacingcommonshocksto theirincomes-in one particulargeographicarea,for example,or on farmersproducingone particular crop, or on one particularkinshipgroup.

Segmentedcreditmarketsin the ruralareasof developingcountriesoften dependon informalcredit,such as local moneylendersf,riendsand relatives, rotatingsavings,and rmalcreditinstitutionstend to operatelocally,usinglocal informationand enforcementmechanisms.

The cost of segmentationis that fundsfail to flow acrossregionsor groups of individualseven thoughthereare potentialgains from doing so, as when needsfor creditdifferacrosslocations.Forexample,a floodmay createa significantdemandfor loans to rebuild.Butbecausecreditinstitutionsarelocalized,suchflows maybe limited.Depositretentionschemes,whichrequirethat some percentageof depositsraisedbe reinvestedin the same region,or the practiceof unitbankingmayexacerbatethe segmentationF. indingthe optimal scope of financialintermediariesmay requirea tradeoff.Local lendersmay havebetterinformationandmaybe moreaccountableto theirdepositorsthan large, national lenders.However,the latter may have betteraccess to welldiversifiedloan portfolios.

Enforcement Problems

Arguablyt,he issueof enforcingloanrepaymenctonstitutesthe centraldifference betweenruralcreditmarketsin developingcountriesand creditmarkets

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elsewhere. In this article, a pure enforcementproblem is defined as a situation in which the borroweris able but unwillingto repay.Most models of creditmarkets discussed below do not concern themselves with enforcement and assume that, where projects are sufficientlyprofitable,loan repaymentis guaranteed.

Enforcement problems are broadly of two kinds. First, the lender must attempt to enforce repayment after a default has occurred. But for this to be worthwhile, the lender must reap a benefit from enforcement that exceeds the cost. And the costs of sanctions, such as seizing collateral, may not be the only cost involved. It is sometimes argued that rich farmers who fail to repay are not penalized because the political costs are too high (see, for example, Khan 1979). Furthermoredebt forgivenessprograms-where a governmentannounces that farmers are forgiven their past debts-are quite frequent. They have been common in Haryana State in India (see India Today 1991), for example, and The Economist (1992) has documented them in Bangladesh.So borrowers, aware that they can default on a loan with impunity, come to regard loans as grants, with little incentive to' use the funds wisely.

Second, enforcement problems are exacerbated by the poor development of property rights mentioned earlier. In both industrial and developing countries, many credit contracts are backed by collateral requirements,but in developing countries the ability to foreclose on many assets is far from straightforward. Land-which, as a fixed asset, might be thought of as an ideal candidate to serve as collateral-is a case in point. In many countries property rights to land are poorly codified, which severely limits its usefulness as collateral. Rights to land are often usufructual, that is, based on using the land, and have limited possibilities for transfer to others, such as a lender who wishes to realize the value of the land as collateral. Reclaiming assets through the courts is similarly not a well-established and routine procedure. (For a general discussion of land rights issues and collateralization in three African countries, see Migot-Adholla and others 1991).

The difficulties of enforcement also help explain the widespread use of informal financial arrangementsin developing countries. Such arrangementscan replace conventional solutions, such as physical collateral, with other mechanisms, such as social ties (social collateral) (Besley and Coate 1991). Informal sanctions may persuade individuals to repay loans in situations where formal banks are unable to do so. Udry (1990), for instance, cites cases of delinquent borrowers being debarred from village ceremonies as a sanction.

Governments can help solve the collateral problem by improving the codification of property rights. In many countries, particularly in Africa, governments have taken steps to improve land registration. Whether these actions have the desired effect is debatable, especially in the short run, where attempts to codify rights may lead to disputes and increased land insecurity (Attwood 1990). Such programs also raise tricky ethical questions about the extent to which countries should be encouraged to adopt Western legal notions of property. In addition, the link between improved property rights and improve-

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