The Theoretical Derivation of Credit Market Segmentation as the Result of a Free Market Process

Information asymmetries make it difficult for banks to assess accurately whetherspecific entrepreneurs are able and/or willing to repay their loans. This leads toimplicit interest rate ceilings, i.e. banks “refuse” to increase their interest ratesbeyond this ceiling as this would lower their net returns. Although the maximuminterest rate increases as the size of enterprises decreases, such ceilings nonethelessconstrain the banks’ ability to set interest rates at a level that would enable them tocover costs. If transaction costs are high, the total costs associated with grantingsmall and medium-sized loans will exceed the maximum average return which thebanks can earn by issuing such loans. For this reason, banks do not lend to smalland medium-sized enterprises, and, as a consequence, these businesses have noaccess to formal sector loans.Because micro and small enterprises have a very high RoI, it is worthwhile forthem to rely on expensive informal loans to finance their operations, at least untilthey reach a certain size. Once they have reached this size, however, it does notmake economic sense for them to continue taking out informal credits, and thus theyface a growth constraint imposed by the credit market. Medium-sized enterprisesearn a lower RoI than small ones, which is why borrowing in the informal creditmarket is not a worthwhile option for them. Moreover, they do not have access tocredit from formal financial institutions, and are thus excluded from obtaining anykind of financing in either of the two credit markets.As the result of free, unregulated market forces we get a stable equilibrium inwhich the credit market is segmented into an informal (small loan) segment, a formal(large loan) segment and, in between, a “non-market” (medium loan) segment