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

Basab Dasgupta ()

No 366, Computing in Economics and Finance 2005 from Society for Computational Economics

Abstract: 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. 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 consumption equivalence

Keywords: informal; credit; and; capital; accumulation (search for similar items in EconPapers)
JEL-codes: E26 O16 O17 (search for similar items in EconPapers)
Date: 2005-11-11
New Economics Papers: this item is included in nep-cfn, nep-dge, nep-ent and nep-fmk
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