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Hugo Till

Poor Economics, Chapter 7: Failing Credit Markets in Developing

In chapter 7 of ‘Poor Economics’, Banerjee and Duflo answer 3 principal questions:
1. Why are credit markets in developing economies failing?
2. How effectively is microfinance correcting this market failure?
3. What are the reasons for its successes/failures?
In my essay I will deal with the first of these.
Despite the large numbers of money lenders in each village, town and city in developing
countries such as India, interest rates vary in the region for 40 to 200%, and the very
poorest often pay even more. The conventional explanation for this is that poorer
borrowers are more likely to default, so creditors charge higher interest rates to
compensate themselves for the debts that will never be repaid. But this explanation is
incomplete; Banerjee points to a study that shows that the median rate of default across
moneylenders in Pakistan stands at just 2% (which would imply an interest rate of just over
2%, assuming no other costs and no profit, instead of the 78% they charge).
In truth, the main reason for these extortionate interest rates are the costs associated with
ensuring low default rates. Lenders need to know basic information about their borrowers
such as their whereabouts and the nature of their business. They also need to ascertain how
trustworthy the borrower is, and how they expect to generate the income to repay the
debt. To further reduce default rates, lenders may want to keep an eye on the borrower to
make sure that their money is being used prudently and focus the debtor’s mind on
repayments. Banerjee and Duflo identify three reasons why monitoring and screening costs
account for such a large proportion of lenders’ costs in emerging markets, when they are far
less significant in developed economies.
Firstly, in developed economies, credit ratings calculated from public records give lenders a
cheap way of determining how trustworthy a borrower is. The lack of good public
information in developing economies means that borrowers must ascertain this for
themselves through highly time-consuming procedures of asking around the community and
visiting individual borrowers.
Weak legal institutions are also highly problematic. In developed economies with competent
judiciaries, rigorous background checks for borrowers are less crucial. For even if a debtor
defaults on a loan, it is usually possible to recoup at least some of the value of the loan by
seizing the collateral or other valuable goods. But in developing economies such as India,
‘40% of cases for asset liquidation were more than eight years pending’ (ibid pg. 165), at
which point, the value of the borrower’s collateral or assets have likely eroded significantly.
Thus, the increased cost of each default necessitates screening and monitoring to reduce
their frequency.
Finally, and most crucially, these costs are fixed and do not vary with the size of the loan, so
the smaller the loan, the greater the screening and monitoring costs will be as a percentage
Hugo Till

of the loan size, leading to these extortionate interest rates on small loans, or lenders simply
determining that small loans are not worthwhile, leading to missing markets. This in
particular explains why banks are unwilling to lend to the poor, leaving them with no choice
but to borrow from less scrupulous money lenders.
On a slightly more tangential note, lenders in developed economies have devised tactics to
reduce the need for vetting. This often take the form of intimidation and coercion, for no
matter how unreliable a borrower is, if their life is in danger, they usually find a way of
paying up. For this reason, these ‘lenders of last resort’ often charge lower rates, but it is
hardly necessary to explain that this does not provide a solution; the social costs of having
thugs extorting money from vulnerable people far outweigh any advantage that lower
interest rates could offer.
Screening and monitoring costs also explain why although credit markets appear to be
highly competitive in emerging economies, competition does not drive interest rates down.
Once a borrower has been vetted by a lender and builds a rapport, they are unlikely to go
elsewhere. This is due to the large time commitment that being vetted involves, each time a
borrower approaches a new lender. Therefore, the high transfer costs of moving to another
lender leads to a large amount of consumer inertia, which gives lenders some degree of
monopoly power to keep interest rates high.
Furthermore, Banerjee notes that rising interest rates due to screening costs can lead to a
multiplier effect. Higher interest rates increase the incentive for borrowers to try and avoid
repaying the loan, which means that lenders must allocate more resources to monitoring
and screening to counter this effect. This in turn raises costs and shifts the supply curve to
the left, increasing equilibrium interest rates yet further. This vicious circle repeats, and
interest rates can skyrocket.
To conclude, Banerjee and Duflo’s analysis of why interest rates for the very poorest are so
high is extremely convincing and largely uncontroversial. They support sound economic
analysis, bringing together ideas about imperfect information, monopoly power as well as
institutional factors with evidence from sources such as ‘The Law Commission of India’ and
World Bank reviews. However, in an attempt to levy some criticism, I will offer a further
potential explanation for the high interest rates, that Banerjee and Duflo have not
accounted for.
Perhaps money lenders are colluding to drive up interest rates. Despite the high number of
money lenders in most developing economies, the hyper localised nature of these credit
markets means that co-operation would only be necessary between lenders in one village,
town, or part of a city. There would be little threat of legal prosecutions due to how opaque
these credit markets are, and the limited ability of regulative bodies to enforce anti-trust
law in developing economies. The possibility of collusion could also help to account for the
extreme variability of interest rates (σ = 38.75) between different villages and towns in
Pakistan identified by Aleem in his 1990 study into rural credit markets, despite similar
screening and monitoring costs. Perhaps money lenders in different villages and towns had
agreed, be it tacitly or overtly, to charge a different interest rate.