reported by Aryeetey et al. (1997). Such informal mutual assistance between non-market
institutions is unobservable to market insurers and its impact appears to be either neg-
ative or positive, depending on the market structure. From their model, it is predicted
that, when formal and informal insurers have the same information, the informal insurance
crowds out formal insurance leading to welfare-inferior outcomes. In contrast, when infor-
mal insurers have a better position in peer monitoring, the existence of informal insurance
is welfare-enhancing. (See, among others, Stiglitz (1990) and Banerjee et al. (1994).)
5.1.2 Vertical linkages
Informal lenders have access to formal banks and so can use funds generated formally for
lending in informal markets. Hoff and Stiglitz (1997), Floro and Ray (1997), Bose (1998)
and Madestam (2009), among others, discuss this vertical interaction between formal and
informal credit sectors. Most of these studies report the adverse effect of government poli-
cies of providing low-cost or subsidized credit to the agricultural sector through the formal
credit institutions such as cooperatives and banks. Hoff and Stiglitz (1997) develop mod-
els to show that with endogenous enforcement costs, government-subsidized formal credit
may not be not able to enhance agricultural investment. Subsidies may attract more mon-
eylenders to enter the informal credit market leading to higher interest rates through three
channels. A rise in new entry may raise the marginal transaction costs (via economies of
scale), increase the marginal enforcement cost of moneylenders due to reduced borrow-
ers’incentives to repay (via enforcement externalities), and reduce the flows of information
about each borrowers’ credit history and thus weaken “reputation effects” that punish de-
faulters. Through these three effects, subsidized funds may eventually raise interest rates
and reduce the availability of loans in the informal sector. Bose (1998) argues that al-
though the informal moneylenders as a whole have some relative advantage in collecting,
screening, and monitoring the information about borrowers’ credit history and invest-
ment behavior, they may also face the problem with the asymmetric information about
the borrower-specific degree of risk. Such heterogeneity in moneylenders and borrowers
brings about adverse composition effects and, in turn, increase interest rates charged by
moneylenders as in Kochar (1997). Floro and Ray (1997) reach a similar conclusion but
with different reasoning. Considering the special case of Philippines, they find that an
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