Risk, wealth, and sectoral choice in rural credit markets.

In developing countries, informal and formal credit sectors coexist in spite of large interest rate differentials. This coexistence is troubling given the recent wave of financial liberalization aimed at broadening and deepening formal credit markets. Two main explanations are offered in the literature. First, the informal sector may be the recipient of "spillover" demand from the formal sector (Bell, Srinivasan, and Udry 1997; Conning 1996; Hoff and Stiglitz 1990). In this view, formal lenders have limited local information and must rely on collateral to solve the moral hazard and adverse selection problems inherent in credit transactions. Informal lenders' ability to substitute information-intensive screening and monitoring for collateral allows them to offer contracts to individuals that are excluded from the cheaper formal sector.

An alternative explanation is that lower transaction costs allow informal lenders to offer loans with lower effective cost (Chung 1995; Kochar 1997; Mushinski 1999). In this view, the informal sector need not be the sector of last resort but instead may be the preferred sector. This latter explanation is important because it emphasizes that multiple dimensions of loan contracts must be considered when analyzing sectoral choice.

In this article, we expand upon this view and argue that an additional, crucial dimension of loan cost, namely, risk, has been neglected. If borrowers are risk averse and insurance markets are underdeveloped, the relevant cost differential across sectors should be thought of in terms of expected utility instead of expected income. We argue that the lower collateral requirements of informal loans imply greater consumption smoothing for borrowers compared to the formal sector alternative. (1) If the cost of this implicit insurance, in terms of lower expected consumption, is not too high, then some borrowers may undertake expected income enhancing investments that they would forego if they only had access to a more risky formal loan. The informal sector, by permitting a reduction in collateral, may thus relax both quantity rationing and another form of nonprice rationing termed "risk rationing" by Boucher, Carter, and Guirkinger (2005).

We draw on several strands of the theoretical literature on credit rationing to formalize these two potential roles of the informal sector. As in Bester (1987) and Schmidt-Mohr (1997), we acknowledge the use of collateral as a means used by lenders to address asymmetric information. The effectiveness of collateral in averting non-price rationing is limited, however, in rural areas of developing countries, where collateral assets are scarce and insurance markets are weak. The premise of our analysis is that informal lenders' better access to local information allows them to offer contracts with lower collateral. As a result, an informal loan may be demanded both by those who cannot post the collateral required by the formal sector and by those who can but are unwilling to do so because of the associated risk. As in Conning (1996), we portray the informal lender's information advantage as the ability to monitor borrowers and impose a penalty for shirking. The ensuing collateral reduction, however, comes at a cost as informal lenders expend resources on monitoring that must be recovered via a higher interest rate. We extend Conning's model, which assumes borrower risk neutrality, to allow for the more realistic assumption of risk aversion. By doing so, our analysis shows that the informal sector not only absorbs the spillover demand of the poorest agents who are excluded from the formal sector, but also may be preferred by a class of agents who could obtain a formal loan.

While it is easy to show that spillover demand derives from the poor, characterizing the location within the wealth distribution of the second group is complicated because of counter-veiling impacts of wealth under risk aversion. We derive sufficient conditions regarding agent preferences to determine the impact of agent wealth on sectoral choice.

The structure of the article is as follows. The next section motivates the ensuing theoretical analysis by using descriptive evidence from several recent household surveys to document the multiple roles played by the informal loan sector. We then lay out a model in which agents choose both activity and loan sector. We next take up the impact of agent wealth on activity and sectoral choice. When farm size if fixed, we show that a fairly strong condition on borrower preferences is required to deliver the intuitive result that the informal sector relaxes formal sector risk rationing for agents that are relatively poor in terms of liquid wealth. The penultimate section extends the model to allow for heterogeneity in farm size. We show that weaker conditions on agent preferences are required for the informal sector to relax formal sector risk rationing for agents that are relatively poor in terms of land wealth. The final section concludes.

Descriptive Evidence on the Roles of the Informal Sector

In this section, we use data from three recent farm-household surveys in Latin America to provide descriptive evidence on the relationship between formal and informal loan sectors and the multiple reasons that farm households seek informal loans. (2) We define three loan sectors. The formal sector consists of regulated financial institutions and includes commercial banks, state development banks, credit unions and, in the case of Peru, rural and municipal banks. The informal sector includes moneylenders, input supply dealers, traders, and agro-processing firms. Finally, the semiformal sector includes unregulated lending institutions such as NGO's and government loan programs.

Table 1 compares key contract terms across the three sectors. (3) The general picture that emerges from table 1 is that in each country the formal sector offers more attractive loans compared to the informal sector with respect to size, interest rate, and maturity. (4) The most striking difference is the case of Peru, where informal loans carry an average annual interest rate of 117%, which is nearly double the interest rate in the formal sector. The same patterns hold in Honduras and Nicaragua.

Table 2 compares participation in the various credit market sectors for households facing positive supply versus no supply from the formal sector. Households with positive supply either obtained a formal loan in the previous twelve months or believed they could obtain one. The dominance of contract terms in the formal sector discussed above suggests that a household would only seek an informal loan if it were denied access to the formal sector. (5) Table 2, however, suggests otherwise. For example in Peru, 17% of households that had access to a formal loan borrowed only from the informal sector, suggesting that these households preferred the informal sector despite the apparently inferior loan terms it offers. In Honduras and Nicaragua, 7% and 6% of households with positive formal supply chose to borrow exclusively from the informal sector. While these percentages are lower than in Peru, overall household participation in any sector of the credit market is also lower. In Honduras and Nicaragua respectively, informal borrowers represent 13% and 20% of households that borrowed and had a choice across sectors.

Why, then, would a borrower prefer the informal sector? A comparison of collateral requirements across the two sectors suggests an answer. A glance back at table 1 reveals that, across these three samples, at least 58% of formal loans required that the borrower post physical assets, typically agricultural land, as collateral. Informal loans, in contrast, required collateral much less frequently. Taken together, the data suggest that borrowers face a choice between lower cost but higher risk (collateral) contracts available in the formal sector and the higher cost but lower risk contracts of the informal sector. (6)

It would seem, then, that the informal sector indeed plays multiple roles. Important fractions of households that are shut out of the formal sector resort to informal loans, suggesting that the informal sector indeed receives spillover demand from the formal sector. Yet the informal sector also appears to be the sector of choice for other households and risk considerations appear to at least partially drive this choice. In Peru, for example, 46% of households that chose the informal sector gave the risk associated with posting collateral as the primary reason for forgoing a formal loan.

Finally, table 2 also reports mean wealth levels for households in each category. Two patterns emerge. First, households shut out of the formal sector are poorer. Second, of those households with access to the formal sector, informal borrowers are poorer than formal borrowers. We now turn to constructing a conceptual framework that can help explain the patterns suggested by this descriptive analysis.

Model Setup

In this section and the next, we develop a model that examines optimal loan contracts in each of two sectors and agents' choice both across sectors and alternative activities. We begin by outlining the key assumptions about preferences, technology, and information and then describe the potential choices that agents may face. The model contains three types of actors: (a) farmers, (b) formal lenders, and (c) informal lenders. All farmers are endowed with one unit of land and labor. Heterogeneity across farmers derives from their endowment of financial wealth, W [member of] [[W.bar], [bar.W]].