Exercise4_07answersheet - Econ 171-EEP 151 Fall 2007 Alain...

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Econ 171-EEP 151 Alain de Janvry Fall 2007 Exercise #4 Microfinance, rural development, and trade Due November 20, 2007 1. Can microfinance succeed in giving access to capital to the poor? Read the article by Beatriz Armendariz and Jonathan Morduch: “Microfinance: Where do we stand?” http://www.economics.harvard.edu/faculty/armendariz/papers/Microfinance_Where_Do_ We.pdf Answers the following questions: 1.1. How do they define the following problems encountered in lending without collateral (3 points): Adverse selection (AS): When lenders lend without collateral they can’t distinguish between risky and safe borrowers in a pool of loan applicants. Therefore the bank must charge the same interest rate to all borrowers and this can trigger the exit of safe borrowers from the credit market. Ex-ante moral hazard (MH): Financial institutions cannot effectively monitor borrowers so they cannot write a credible contract that enforces prudent behavior. Since borrowers have no collateral, they do not face the full consequence of failure so they are tempted to undertake riskier projects than the bank would like. Ex-post moral hazard: because financial institutions cannot observe the returns of a project and because there is no collateral on the line, borrowers have an incentive to pretend that their loans are low or to strategically default on a loan. 1.2. According to them, and based on what you know from class, how is group lending expected to solve the problems of (4 points): Adverse Selection (AS): Villagers have better information about the relative riskiness of their neighbors. So safe borrowers will form groups among themselves and risky borrowers will form group among themselves. (“assortative matching”). Safe borrowers will have to repay less frequently for their peers than risky borrowers, so they face a lower effective interest rate. Ex-ante MH: Because groups agree to shoulder a monetary penalty if a peer defaults on a loan, the group has an incentive to monitor each other and can threaten to impose social sanctions when risky projects are chosen. Insurance: If an idiosyncratic shock occurs and a borrower cannot repay his loan, then members of his group can cover/insure him.
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Ex-post MH: Borrower’s neighbors (other members of the group) can observe the true return of the project and therefore can threaten with social sanctions if the borrower does not declare his/her true returns and repay what he can. 1.3. Can group lending fail to resolve each of these four problems? (1 point) Yes, each of them can fail. Insurance fails if the group does not have the resources to bail out someone from their group. Ex-ante moral hazard can fail if group members live far away from each other and therefore cannot monitor each others actions. Ex-post moral hazard can fail if group decides to collude together against the lender and
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Exercise4_07answersheet - Econ 171-EEP 151 Fall 2007 Alain...

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