The Problems Intrinsic to Financing

Few debts are perfectly safe- there is typically some uncertainty about whether a borrower will repay. To make up for the uncertainty, a lender seeks a higher premium in the form of interest rates on the amount lent. The problems of uncertainty are exacerbated because not all borrowers are intrinsically honest. Without extensive information on a borrower’s past credit history, it is hard for a lender to tell the honest from the dishonest. Even if there is a default, it is difficult to separate bad luck from dishonest practices. Since the dishonest are hard to identify and punish, lenders with limited information again have to resort to charging high rates.

There is a limit, however, to the rates a lender can charge. Increasing the interest rates gives rise to the problem of adverse selection. Honest borrowers who intend to repay are very sensitive to the interest rate. They expect to bear the full burden of repaying the higher rate. Therefore, increasing the rate of interest discourages the honest borrowers from borrowing and encourages dishonest ones who do not intend to repay in the first place. The lender, therefore, increases the rate only till the point where all the honest borrowers are discouraged from lending. At that point, the lender knows the only customers willing to borrow are the ones who will not repay. In short, there may be no interest rate that allows lending to be profitable, so the lender simply denies credit to applicants who do not have a solid credit history. In an underdeveloped system, this leaves a large fraction of population without any access to credit.

Uncertainty and Dishonesty are not the only problems a lender faces. Even an intrinsically honest borrower may be forced to take actions contrary to the lender’s interest — a phenomenon known as moral hazard — when terms of the repayment are poorly structured. For example if repayments become too onerous for an unforeseen reason, the borrower may see that the only way he can hope to repay the loan is by taking on greater risk. This may be against the lender’s interest because in desperate times even an honest borrower may be forced to take on desperate measures resulting from lack of proper judgment. In a developed financial system, the lender has the information to know when the borrower’s financing terms start creating perverse incentives for the borrower. He has the skills to write the right kind of new contracts and can rely on an efficient legal system to help restructure the old contracts and enforce new ones.

In a system in which the techniques of contract design, contract negotiation and contract enforcement are underdeveloped it is hard to provide borrowers with the right incentives throughout the term of the project, so lenders are again reluctant to lend.