Risk, wealth and sectoral choice in rural credit markets

Abstract: We develop a model which suggests a re-evaluation of the role of the informal credit sector in developing countries. The informational advantage of informal lenders is portrayed as the ability to monitor borrowers. Monitoring reduces the incentive problem and allows for contracts with lower collateral. This enables informal lenders to serve two types of clients: 1) Those who cannot post the collateral required by the formal sector; and 2) Those who are able but do not want to post collateral. The model is thus consistent with the conventional view of the informal sector as recipient of spillover demand (quantity rationed) from the formal sector. It also demonstrates an additional role of the informal sector- namely as provider of insurance as the lower collateral requirement implies greater consumption smoothing across states of nature