expansion of credit available to informal lenders through the formal sector might trigger
aggressive lending (like a credit war). In a repeated game framework, moneylenders might
then decide to collude among themselves leading to higher interest rates.
The findings in Madestam (2009) are in line with the above studies using a model that
like those assumes formal and informal credit sectors, but that in addition assumes that
informal moneylenders are heterogeneous. Two types of lenders exist in the informal credit
market: rich informal lenders who do not to borrow formally to lend informally, and poorer
informal lenders who must access banks to fund their business. The model rationalizes
the coexistence of formal and informal credit markets assuming that formal and informal
lenders face different agency and monitoring constraints (for example, informal lenders are
able to closely monitor borrowers who are usually known clients whilst banks have limited
information on moral hazard at the investment stage). The main findings of the paper is
that the existence of informal finance results in three effects. First, informal credit leads to
the “investment effect” such that additional informal finance increases the investment of
bank rationed borrowers by channeling bank funds to informal lending. Second, informal
credit generates a “disciplinary effect”. Since borrowers in informal markets do not need to
pay agency costs that usually arise from bank finance, the borrowers’ return to investment
is higher than otherwise and they have less incentives to default, leading to increased bank
lending. Finally, the agency problem leads to the “rent-extraction effect”. By letting
informal lenders with good credit or collateral channel bank funds to informal borrowers,
banks are able to avoid high agency costs arising from directly lending to poor borrowers (in
addition to the monitoring problem), preventing borrowers from accessing bank finance.
As a result, if the rent-extraction effect prevails, borrowers are worse off. Using this
model, Madestam (2009) also investigates the role of market power in the banking sector,
reaffirming the general finding that the stronger this is the less efficient the credit market
equilibrium. When the banking sector has higher market power, the rent-extraction effect
dominates, and as a corollary informal credit markets are more prevalent .
5.2 Informal credit markets and trading frictions
As discussed, one way to model credit rationing is by introducing imperfect information.
While models with moral hazard and adverse selection in financial markets have been
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