Asymmetric information, capacity constraint and segmentation in credit markets

Abstract

PurposeThe purpose of this study is to propose a model of competition between a formal lender (bank) and an informal lender (moneylender) with informational asymmetry between these two lenders. Further, the authors introduce capacity constraint on the lending capacity of the moneylender and assume that borrowers differ in risk and wealth.Design/methodology/approachThe solution concept of Nash equilibrium has been used to derive the optimal strategies of the lenders.FindingsThe equilibrium strategies in most of the results depend on the difference between the expected returns from risky and safe projects where the risky project has higher expected returns. The credit market is segmented in terms of risk and wealth levels. Rationing of poor safe borrowers from the credit market is inevitable when the moneylender's capacity is sufficiently small, suggesting a low-income trap for them. Further, when moneylender has capacity constraint of some form, a zero-profit outcome is never a Nash equilibrium outcome.Research limitations/implicationsThere is a possibility of collusion between the lenders. However, the authors do not derive all possible outcomes under capacity constraintPractical implicationsWhen the informal lender has limited capacity, competition between formal and informal lenders may not alleviate credit rationing, instead aggravate the problem. Thus, the government should devise policies to ensure credit availability to resource poor householdsOriginality/valueWhile the literature models strategic interaction between lenders under the assumption of zero-profit (Bertrand Paradox) condition, this study shows that zero profit is not the only outcome under such a set-up. Also, in presence of capacity constraint of the moneylender, a zero-profit outcome is never a Nash equilibrium outcome for the lenders. There is an optimal contract at which the lenders differentiate in terms of repayment and collateral and earn positive profits under certain conditions.