Financial contracts in formal and informal credit markets: A theoretical and empirical analysis

This dissertation provides an explanation for the co-existence of formal and informal lenders in rural credit markets of developing countries. Furthermore, it justifies the complementary activities of the two lending sectors. We assume that formal lenders find it too costly to observe the output levels of borrowers. As a result, financial contracts issued by this sector are rigid in that if a borrower does not repay a certain amount, he is excluded from future loans. On the other hand, the informal lender's informational advantage allows him to disburse loans regardless of the borrower's outcome. In certain cases, his high opportunity cost of lending would prevent him from participating as a primary lender. He can still participate as a residual lender, disbursing loans to borrowers who have been excluded by the formal sector. We then relate the possible outcomes to a set of village-level variables and find that the presence of moneylenders significantly increases the lending space. The empirical section attempts to test two different implications of the theoretical work: one, on the presence of informal lenders and two, on the role of informal lenders. The theory predicts that in villages with high income variation formal lenders should not exist alone. It also predicts that if informal lenders serve a residual role, then repayments to formal lenders should not fluctuate with income. For this purpose, we use two different data sets: cross-section and longitudinal sets from India. The results support the hypothesis that villages with high income variation are associated with higher share of informal lenders. Also, repayments to banks indicate that informal lenders serve an important role as residual lenders.