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

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. The 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 consumptiuon equivalence.

Endogenous Growth in the Presence of Informal Credit Markets: A Comparative Analysis Between Credit Rationing and Self-Revelation Regimes

This paper examines whether the presence of informal credit markets reduces the cost of credit rationing in terms of growth. In a dynamic general equilibrium framework, we assume that firms are heterogenous with different degrees of risk and households invest in human capital development. With the help of Indian household level data we show that the informal market reduces the cost of rationing by increasing the growth rate by 0.7 percent. This higher growth rate, in the presence of an informal sector, is due to the ability of the informal market to separate the high risk from the low risk firms thanks to better information. But even after such improvement we do not get the optimum outcome. The findings, based on our second question, suggest that the revelation of firms' type, based on incentive compatible pricing, can lead to almost 2 percent higher growth rate as compared to the credit rationing regime with informal sector.