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

Basab Dasgupta ()

No 2004-32, Working papers from University of Connecticut, Department of 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. 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.

Keywords: credit rationing; informal credit markets; self revelation mechanism (search for similar items in EconPapers)
JEL-codes: E26 O16 O17 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2004-10
New Economics Papers: this item is included in nep-dge and nep-mfd
Note: I am really grateful to my advisors, Christian Zimmermann and Steven Ross for their guidance and valuable comments. Any types of errors in this paper are mine.
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Citations: View citations in EconPapers (4)

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Working Paper: Capital Accumulation in the Presence of Informal Credit Contract: Does Incentive Mechanism Work Better than Credit Rationing Under Asymmetric Information? (2005)
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