Risk, wealth and sectoral choice in rural credit markets

We model 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 both individuals who cannot post the collateral required by the formal sector and those who are able but do not want to post collateral. The model is consistent with the conventional view of the informal sector as recipient of spillover demand from the formal sector. It also shows that the informal sector may provide partial insurance as the lower collateral requirement implies greater consumption smoothing for borrowers. Key words: credit rationing, informal credit, informal sector, moral hazard, risk rationing. 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 liberaliza-tion aimed at broadening and deepening for-mal credit markets. Two main explanations ar