New Economics Papers
on Financial Markets
Issue of 2005‒11‒12
28 papers chosen by

  1. Usury Ceilings, Relationships and Bank Lending Behavior: Evidence from Nineteenth Century By Howard Bodenhorn
  2. On the Rationale of Bank Lending in Pre-Crisis Thailand By Menkhoff, Lukas; Chodechai Suwanaporn, Chodechai
  3. Banking system stability - a cross-Atlantic perspective By Philipp Hartmann; Stefan Straetmans; Casper de Vries
  4. Explaining exchange rate dynamics - the uncovered equity return parity condition By Elizaveta Krylova; Lorenzo Cappiello; Roberto A. De Santis
  5. An Investigation of the Role of Cross-Border Spillover of Returns and Volatility in the Estonian Stock Market By Alar Kein
  6. Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence By Sean D. Campbell; Francis X. Diebold
  7. Cross-dynamics of volatility term structures implied by foreign exchange options By Elizaveta Krylova; Jussi Nikkinen; Sami Vähämaa
  8. Foreign Exchange Market Microstructure By Martin D. D. Evans (Georgetown University)
  9. Market power, innovative activity and exchange rate pass-through in the euro area By Sophocles N. Brissimis; Theodora S. Kosma
  10. Deposit Insurance and Depositor Discipline: Direct Evidence on Bank Switching Behavior in Japan By Noriko Inakura; Satoshi Shimizutani; Ralph Paprzycki
  11. Understanding Order Flow By Martin D. D. Evans; Richard K. Lyons
  12. A comparison of different trading protocols in an agent-based market By Paolo Pellizzari; Arianna Dal Forno
  13. The Portfolio Allocation Effects of Investor Sentiment about the Ability of Managers to Beat the Market By Flynn, Sean M.
  14. Shareholder lockup agreements in French nouveau marche and German neuer markt IPOs By Goergen,M.; Renneboog,L.; Khursed,A.
  15. Distilling co-movements from persistent macro and financial series By Karim Abadir; Gabriel Talmain
  16. Performance evaluation of ethical mutual funds in slump periods By Antonella Basso; Stefania Funari
  17. A Portfolio View of Consumer Credit By David K. Musto; Nicholas S. Souleles
  18. Arbitrage in the foreign exchange market: Turning on the microscope By Q. Farooq Akram,; Dagfinn Rime; Lucio Sarno
  19. Elasticities of Demand for Consumer Credit By Dean Karlan; Jonathan Zinman
  20. The subsidiarity principle and the negative spread. A case in point for the governance of state-owned banks. By Rodolfo Apreda
  21. Price Political Uncertainty and Stock Market Returns: Evidence from the 1995 Quebec Referendum By Marie-Claude Beaulieu; Jean-Claude Cosset; Naceur Essaddam
  22. How Homogenous are Currency Crises? A Panel Study using Multiple-Response Models By Tassos Anastasatos; Ian R. Davidson
  23. Insider trading, news releases and ownership concentration By Fidrmuc,J.; Goergen,M.; Renneboog,L.
  24. Competitive equilibrium with asymmetric information : an existence theorem for numeraire assets. By lionel de Boisdeffre
  25. Financial Market in the Laboratory, an Experimental Analysis of some Stylized Facts By Andrea Morone
  26. Public-to-private transactions : LBOs, MBOs, MBIs and IBOs By Renneboog,L.; Simons,T.

  1. By: Howard Bodenhorn
    Abstract: Few pieces of economic regulation are ubiquitous as usury limits. Similarly, few economic principles are as widely accepted as the belief that interference with freely contracted prices leads to market distortions, and many studies of financial markets find that usury limits negatively affect credit availability. This study shows that when no regulatory authority monitors and stands ready to punish violators of the usury limit when intermediaries and borrowers form long-term relationships, banks and borrowers regularly contract for interest rates in excess of the usury ceiling. Time series analysis reveals limited effects on credit availability when market rates exceed the usury ceiling. Cross-sectional analysis of individual loan contracts also shows that the positive effect of a long-term relationship offsets the negative effect of the usury limit on credit availability.
    JEL: N2 N8 G2
    Date: 2005–11
  2. By: Menkhoff, Lukas; Chodechai Suwanaporn, Chodechai
    Abstract: Evidence from credit files is provided to examine bank lending determinants of Thai commercial banks. Their lending practice follows reasonable patterns as a standard set of variables, including indirect risk variables, explains much of the variance in interest rate spread. Reflecting institutional differences with mature markets, we find higher importance of relationship banking and risk control via credit availability. Information about later default reveals prudent relationship lending. However, banks could have made better use of available information about borrowers' riskiness. These findings do not support a general verdict of bad banking but indicate room to improve lending decisions.
    Keywords: Financial system, bank lending, relationship lending, financial crises, emerging economies, Thailand
    JEL: G21 O16
    Date: 2005–11
  3. By: Philipp Hartmann (European Central Bank, DG-Research, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Stefan Straetmans (Limburg Institute of Financial Economics (LIFE), Economics Faculty, Maastricht University, P.O. Box 616, 6200 MD Maastricht, The Netherlands); Casper de Vries (Faculty of Economics, Erasmus University Rotterdam, P.O. Box 1738, 3000 DR Rotterdam,The Netherlands)
    Abstract: This paper derives indicators of the severity and structure of banking system risk from asymptotic interdependencies between banks’ equity prices. We use new tools available from multivariate extreme value theory to estimate individual banks’ exposure to each other (“contagion risk”) and to systematic risk. By applying structural break tests to those measures we study whether capital markets indicate changes in the importance of systemic risk over time. Using data for the United States and the euro area, we can also compare banking system stability between the two largest economies in the world. For Europe we assess the relative importance of cross-border bank spillovers as compared to domestic bank spillovers. The results suggest, inter alia, that systemic risk in the US is higher than in the euro area, mainly as cross-border risks are still relatively mild in Europe. On both sides of the Atlantic systemic risk has increased during the 1990s.
    Keywords: Banking; Systemic Risk; Asymptotic Dependence; Multivariate Extreme Value Theory; Structural Change Tests.
    JEL: G21 G28 G29 G12 C49
    Date: 2005–09
  4. By: Elizaveta Krylova (European Central Bank, Market Operations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Lorenzo Cappiello (DG-Research, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Roberto A. De Santis (DG Economics, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
    Abstract: By employing Lucas’ (1982) model, this study proposes an arbitrage relationship – the Uncovered Equity Return Parity (URP) condition – to explain the dynamics of exchange rates. When expected equity returns in a country/region are lower than expected equity returns in another country/region, the currency associated with the market offering lower returns is expected to appreciate. First, we test the URP assuming that investors are risk neutral and next we relax this hypothesis. The resulting risk premia are proxied by economic variables, which are related to the business cycle. We employ differentials in corporate earnings’ growth rates, short-term interest rate changes, annual inflation rates, and net equity flows. The URP explains a large fraction of the variability of some European currencies vis-à-vis the US dollar. When confronted with the naïve random walk model, the URP for the EUR/USD performs better in terms of forecasts for a set of alternative statistics.
    Keywords: Foreign exchange markets; asset pricing; random walk; UIP; GMM.
    JEL: F31 G15 C22 C53
    Date: 2005–09
  5. By: Alar Kein (Faculty of Economics and Business Administration, Tallinn University of Technology)
    Abstract: The paper examines the role of foreign stock markets’ price and volatility movements in the price and volatility movements in the Estonian stock market. Using daily log returns from July 8th, 1996 through December 31st, 2003 and applying a VAR-EGARCH framework, the author finds that there is a spillover of returns and volatility from foreign stock markets into the Estonian stock market. It is found that the stock prices in Estonia are influenced by the movement of prices on the markets of Denmark, Russia, Finland, the Czech Republic, Poland and the U.S.A. In general, the response to exogenous price movements is found to be contemporaneous, same-directional and symmetric, while the revealed impact of exogenous volatility-changes is rather market-specific and often asymmetric. The author also finds that the influence of the Finnish market on the Estonian market has significantly increased after the HEX-Group acquired the majority share in the Tallinn Stock Exchange and the integration of the Estonian stock market with the Finnish stock market began in April 2001.
    Keywords: stock returns, cross-border spillover of returns, cross-border spillover of volatility
    JEL: G12 G14 G15 G19
  6. By: Sean D. Campbell; Francis X. Diebold
    Abstract: We explore the macro/finance interface in the context of equity markets. In particular, using half a century of Livingston expected business conditions data we characterize directly the impact of expected business conditions on expected excess stock returns. Expected business conditions consistently affect expected excess returns in a statistically and economically significant counter-cyclical fashion: depressed expected business conditions are associated with high expected excess returns. Moreover, inclusion of expected business conditions in otherwisestandard predictive return regressions substantially reduces the explanatory power of the conventional financial predictors, including the dividend yield, default premium, and term premium, while simultaneously increasing R-squared. Expected business conditions retain predictive power even after controlling for an important and recently introduced non-financial predictor, the generalized consumption/wealth ratio, which accords with the view that expected business conditions play a role in asset pricing different from and complementary to that of the consumption/wealth ratio. We argue that time-varying expected business conditions likely capture time-varying risk, while time-varying consumption/wealth may capture time-varying risk aversion.
    JEL: G12
    Date: 2005–11
  7. By: Elizaveta Krylova (European Central Bank, Market Operations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Jussi Nikkinen (University of Vaasa, Department of Accounting and Finance, P.O. Box 700, 65101 Vaasa, Finland); Sami Vähämaa (University of Vaasa, Department of Accounting and Finance, P.O. Box 700, 65101 Vaasa, Finland)
    Abstract: This paper examines the cross-dynamics of volatility term structures implied by foreign exchange options. The data used in the empirical analysis consist of daily observations of implied volatilities for OTC options on the euro, Japanese yen, British pound, Swiss franc, and Canadian dollar, quoted against the U.S. dollar. The empirical findings demonstrate that two common factors can explain a vast proportion of the variation in volatility term structures across currencies. Furthermore, the results indicate that the euro is the dominant currency, as the implied volatility term structure of the euro is found to affect all the other volatility term structures, while the term structure of the euro appears to be virtually unaffected by the other currencies. Finally, our results reveal a rather deviant relation between the volatility term structures of the euro and Swiss franc by providing evidence of significant nonlinearities in the relationship between these two currencies.
    Keywords: Implied volatility; volatility term structure; foreign exchange options.
    JEL: F31 G13 G15
    Date: 2005–09
  8. By: Martin D. D. Evans (Georgetown University) (Department of Economics, Georgetown University)
    Abstract: This paper provides an overview of the recent literature on Foreign Exchange Market Microstructure. Its aim is not to survey the literature, but rather to provide an introductory tour to the main theoretical ideas and empirical results. The central theoretical idea is that trading is an integral part of the process through which information relevant to the pricing of foreign currency becomes embedded in spot rates. Micro-based models study this information aggregation process and produce a rich set of empirical predictions that find strong support in the data. In particular, micro-based models can account for a large proportion of the daily variation in spot rates. They also supply a rationale for the apparent disconnect between spot rates and fundamentals. In terms of forecasting, micro-based models provide out-of-sample forecasting power for spot rates that is an order of magnitude above that usually found in exchange-rate models. Classification-JEL Codes: F3, F4, G1
    Keywords: Exchange Rates, Microstructure, Information Aggregation, FX Trading.
  9. By: Sophocles N. Brissimis (Bank of Greece and University of Piraeus. Address: 21 E.Venizelos Ave., 10250 Athens, Greece.); Theodora S. Kosma (Corresponding author: Athens University of Economics and Business (AUEB), 76 Patission Street, 10434 Athens, Greece.)
    Abstract: This paper examines exchange rate pass-through in the euro area by accounting for the impact of exchange rate changes on exporting firms’ market power, cost structure and competitiveness. An international oligopoly model where exporting firms simultaneously decide on their pricing and innovation strategies is used as the basis for the econometric analysis. The estimations are carried out on data for manufacturing imports of three large euro area countries (Germany, France, Netherlands) from three major non-euro area import suppliers (US, Japan, UK). The results show that exporting firms’ price and innovation decisions in each source country are jointly determined and that total pass-through to euro area import prices is low. There are also indications that other factors, such as interactions with domestic producers, may be important for the determination of pass-through. Finally, euro area import prices are found to be sticky in local currency in the short run.
    Keywords: Exchange rate pass-through; market power; innovative activity; multivariate cointegration; euro exchange rate.
    JEL: C32 F39 L13 O31
    Date: 2005–10
  10. By: Noriko Inakura; Satoshi Shimizutani; Ralph Paprzycki
    Abstract: As Japan's financial system moves toward a more market oriented one, depositor discipline is expected to play a larger role in the monitoring of the country's banks. Relying on detailed survey data on households' bank switching behavior matched with banks' financial data, we examine households' response to bank risk and different deposit insurance schemes. We find that bank switching in response to risk was more frequent in 2001 than in 1996 and that households' choice of bank provides an adequate reflection of banks' financial health. We also examine the determinants of households' knowledge of the deposit insurance scheme and find that income, the amount of households' financial assets, and educational attainment are all significant factors. What is more, households' extent of knowledge regarding the deposit insurance scheme was an important determinant of bank switching behavior. The results suggest that depositor discipline appears to work and could play an important supplementary role in monitoring the banking sector.
    Keywords: depositor discipline, deposit insurance, pay-off, dopositor-level data
    JEL: G21 G32
    Date: 2005–10
  11. By: Martin D. D. Evans; Richard K. Lyons
    Abstract: This paper develops a model for understanding end-user order flow in the FX market. The model addresses several puzzling findings. First, the estimated price-impact of flow from different end-user segments is, dollar-for-dollar, quite different. Second, order flow from segments traditionally thought to be liquidity-motivated actually has power to forecast exchange rates. Third, about one third of order flow's power to forecast exchange rates one month ahead comes from flow's ability to forecast future flow, whereas the remaining two-thirds applies to price components unrelated to future flow. We show that all of these features arise naturally from end-user heterogeneity, in a setting where order flow provides timely information to market-makers about the state of the macroeconomy.
    JEL: F3 F4 G1
    Date: 2005–11
  12. By: Paolo Pellizzari (Dept. of Applied Mathematics); Arianna Dal Forno (Dept. of Applied Mathematics)
    Abstract: We compare price dynamics of different market protocols (batch auction, continuous double auction and dealership) in an agent-based artificial exchange. In order to distinguish the effects of market architectures alone, we use a controlled environment where allocative and informational issues are neglected and agents do not optimize or learn. Hence, we rule out the possibility that the behaviour of traders drives the price dynamics. Aiming to compare price stability and execution quality in broad sense, we analyze standard deviation, excess kurtosis, tail exponent of returns, volume, perceived gain by traders and bid-ask spread. Overall, a dealership market appears to be the best candidate in this respect, generating low volume and volatility, virtually no excess kurtosis and high perceived gain.
    Keywords: Artificial markets, Agent-based models, Microstructural architectures
    JEL: C8
    Date: 2005–11–04
  13. By: Flynn, Sean M. (Vassar College Department of Economics)
    Abstract: I present a model that can transform discounts on closed-end mutual funds into a measure of investor sentiment about the ability of fund managers to beat the market. This measure of sentiment varies positively with capital flows into actively managed open-end mutual funds, but negatively with capital flows into passively managed index funds. Investors appear to re-allocate their portfolios between actively and passively managed investment vehicles based on expectations about by how much managers will beat or trail the market.
    Date: 2005–10
  14. By: Goergen,M.; Renneboog,L.; Khursed,A. (TILEC (Tilburg Law and Economics Center))
    Date: 2004
  15. By: Karim Abadir (University of York, Heslington,York YO10 5DD, United Kingdom); Gabriel Talmain (University of York, Heslington,York YO10 5DD, United Kingdom)
    Abstract: We provide a methodology to disentangle the long-run relation between variables from their own dynamics. Macroeconomic and aggregate financial series have a high degree of inertia. If this persistence is not properly accounted for, spurious correlations will give rise to paradoxes. Our procedure shows that the Uncovered Interest Parity (UIP) puzzle evaporates when the dynamics are properly modelled: the forward premium loses all the predictive power that it seemed to have. We also show how the stock market grows in long cycles around a trend given by GDP, in a stable relation that does not break.
    Keywords: ACF-based GLS procedure; Autocorrelation Function; Long memory; Nonlinearities; Uncovered Interest Parity anomaly.
    JEL: E37
    Date: 2005–09
  16. By: Antonella Basso (Dipartimento di Matematica Applicata Università Ca' Foscari Venezia); Stefania Funari (Dipartimento di Matematica Applicata Università Ca' Foscari Venezia)
    Abstract: In this paper we tackle the problem of the presence of negative average rate of returns in the computation of the performance of ethical mutual funds. The presence of these negative values raises problems both in the computation of the classical performance indicators and in DEA modeling. In this paper we propose a suitably adjusted DEA model which allows the presence of non negative outputs. The model is applied to data on the UK market of ethical mutual funds.
    Keywords: Performance evaluation, ethical mutual funds, data envelopment analysis
    JEL: C6 D5 D9
    Date: 2005–11–04
  17. By: David K. Musto; Nicholas S. Souleles
    Abstract: To compute risk-adjusted returns and gauge the volatility of their portfolios, lenders need to know the covariances of their loans' returns with aggregate returns. Cross-sectional differences in these covariances also provide insight into the nature of the shocks hitting different types of consumers. We use a unique panel dataset of credit bureau records to measure the 'covariance risk' of individual consumers, i.e., the covariance of their default risk with aggregate consumer default rates, and more generally to analyze the cross-sectional distribution of credit, including the effects of credit scores. We obtain two key sets of results. First, there is significant systematic heterogeneity in covariance risk across consumers with different characteristics. Consumers with high covariance risk tend to also have low credit scores (high default probabilities). Second, the amount of credit obtained by consumers significantly increases with their credit scores, and significantly decreases with their covariance risk (especially revolving credit), though the effect of covariance risk is smaller in magnitude.
    JEL: E21 E51 G21
    Date: 2005–11
  18. By: Q. Farooq Akram, (Norges Bank (Central Bank of Norway)); Dagfinn Rime (Norges Bank (Central Bank of Norway)); Lucio Sarno (University of Warwick and CEPR)
    Abstract: This paper investigates the presence and characteristics of arbitrage opportunities in the foreign exchange market using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency, obtained from Reuters on special order. We provide evidence on the fre- quency, size and duration of round-trip and one-way arbitrage opportunities in real time. The analysis unveils the existence of numerous short-lived arbitrage oppor- tunities, whose size is economically significant across exchange rates and comparable across different maturities of the instruments involved in arbitrage. The duration of arbitrage opportunities is, on average, high enough to allow agents to exploit devia- tions from the law of one price, but low enough to explain why such opportunities have gone undetected in much previous research using data at lower frequency.
    Keywords: exchange rates; arbitrage; foreign exchange microstructure
    JEL: F31 F41 G14 G15
    Date: 2005–11–09
  19. By: Dean Karlan (Economic Growth Center, Yale University); Jonathan Zinman (Dartmouth College)
    Abstract: The price elasticity of demand for credit has major implications for macroeconomics, finance, and development. We present estimates of this parameter derived from a randomized trial. The experiment was implemented by a consumer microfinance lender in South Africa and identifies demand curves that, while downward-sloping with respect to price, are flatter than recent estimates in both developing and developed countries throughout most of a wide price range. However, demand becomes highly price sensitive at higher-than-normal rates. We discuss several interpretations of this kink and present some related evidence. We also find that loan size is far more responsive to changes in loan maturity than to changes in interest rate. This pattern is more pronounced among lower income individuals, a comparative static that has been observed in the United States as well and is consistent with liquidity constraints that decrease with income.
    Keywords: Credit Markets, Microfinance, Demand Elasticity, Development Finance, Maturity Elasticity, Consumer Credit
    JEL: D1 D9 E2 G2 O1
    Date: 2005–10
  20. By: Rodolfo Apreda
    Abstract: This paper sets forth a new perspective to address some problems that arise from the mixed governance nature of a state-owned bank. Firstly, it stresses that the principle of subsidiarity is at the root of decision-making processes in which the bank involves itself on the grounds of political demands. Secondly, it focuses on the uses and misuses of the principle of subsidiarity, putting forward the notion of the subsidiarity portfolio to redress misuses and enhance the governance of these institutions. Next, it defines the assets and liabilities portfolios of the bank and, by means of a break-even analysis of those portfolios'returns, inclusive of the costs-benefit structure, it introduces the rate of subsidiarity. Afterwards it moves on to the negative spread to measure up how far the subsidiarity abuse acts upon the return and costs-benefit structure of the bank. Lastly, it enlarges about likages between risk and subsidiarity on the one hand, and quasi-fiscal activities on the other hand.
    Keywords: subsidiarity, governance, state-owned banks, spread, quasi-fiscal activities
    JEL: G2 H1 G3
    Date: 2005–11
  21. By: Marie-Claude Beaulieu; Jean-Claude Cosset; Naceur Essaddam
    Abstract: In this study, we investigate the short run effect of the October 30th, 1995 Quebec referendum on the common stock returns of Quebec firms. Our results show that the uncertainty surrounding the referendum outcome had an impact on stock returns of Quebec firms. We also find that the effect of the referendum varied with the political risk exposure of Quebec firms, that is, the structure of assets and principally the degree of foreign involvement.
    Keywords: Political uncertainty, stock market returns, 1995 Québec referendum
    JEL: G12 G14 G15 G31
    Date: 2005
  22. By: Tassos Anastasatos (Dept of Economics Univ. of Loughborough); Ian R. Davidson (Business School Univ. of Loughborough)
    Abstract: This paper presents formal evidence that currency episodes display heterogeneity in terms of their evolution, their impact on the inflicted economy and their links with financial, political and macroeconomic fundamentals. Limited-dependent variable models for ordered and unordered outcomes along with their heteroskedastic and random effects extensions are applied on a large panel of data comprising 40 years of monthly observations on 23 developed countries. Heterogeneity, complemented by indications of self-fulfilling expectations and noise, suggest that time and region specific predictive approaches and policy responses are more useful than trying to base analysis and policy decisions on more general patterns. Results are established with formal specification tests.
    Keywords: Currency crises; speculative pressure; exchange rate; devaluation; Limited-dependent variable models.
    JEL: F31 C23 C25 E44 G15
    Date: 2004–12
  23. By: Fidrmuc,J.; Goergen,M.; Renneboog,L. (TILEC (Tilburg Law and Economics Center))
    Date: 2005
  24. By: lionel de Boisdeffre (CERMSEM)
    Abstract: In a general equilibrium model of incomplete markets with nominal assets and adverse selection, Cornet-De Boisdeffre (3) introduced refined concepts of "no-arbitrage" prices and equilibria, which extended to the asymmetric information. We now present the model with numeraire assets and study its existence properties. We show that equilibrium exists, as long as financial markets preclude arbitrage, under similar standard conditions, whether agents have symmetric or asymmetric information. This result departs from the rational expectations' outcome and extends to the asymmetric setting the classical existence property of symmetric information models with numeraire assets.
    Keywords: General equilibrium, asymmetric information, arbitrage, inference, existence of equilibrium.
    JEL: D52
    Date: 2005–03
  25. By: Andrea Morone
    Abstract: This paper purports to provide experimental evidence explaining a number of stylized facts associated with the behaviour of financial returns, in particular, the fat tailed nature of their distribution and the persistence in their volatility. By means of a laboratory experiment, we will investigate the effect of quantity and quality of information, present in a financial market, upon its stylized facts, showing how both quality and quantity of information might have an impact on volatility clustering and the emergence of fat tail returns.
    Keywords: herd behaviour, fat tail volatility clustering
    JEL: C91 D82 D83
    Date: 2005–11
  26. By: Renneboog,L.; Simons,T. (TILEC (Tilburg Law and Economics Center))
    Date: 2005
  27. By: Sarbajit Chaudhuri (Dept. of Economics, Calcutta University)
    Abstract: In this paper, a model of interaction of formal and informal credit markets has been developed where the bank official (the ultimate provider of formal credit) faces a lending constraint. The bank official takes a bribe from the borrowers to disburse formal credit and he deliberately debars some potential borrowers from getting bank credit. Inadequate supply of formal credit and exclusion of a few borrowers by the official create a market for informal credit. The bank official and the moneylender (the supplier of informal credit) play a non-cooperative game in determining the bribing rate and the informal interest rate simultaneously. The central objective of the paper is two-fold. First, it shows that an agricultural credit subsidy policy may be counterproductive even when formal and informal credits are substitutes. This is contrary to the Gupta and Chaudhuri (1997) result that a credit subsidy policy is counterproductive only when the two types of credit are complementary to each other. Secondly, the paper considers two alternative ways of formulating a credit subsidy policy: (1) through an increase in the aggregate volume of formal credit supplied to the borrowers, keeping the formal sector interest rate at a reasonable level; and, (2) through a decrease in the rate of interest charged on this type of credit. The paper shows that if a credit subsidy policy is undertaken via the first path, it is actually able to lower the informal sector interest rate and improve both the agricultural productivity and welfare of the farmers. This result is crucial because all the earlier papers in this line have analyzed the effects of a credit subsidy policy through the second route and found it to be counterproductive in the presence of corruption in the distribution of formal credit.
    Keywords: Farmer; moneylender; bank official; formal credit; non- cooperative game; informal interest rate; credit subsidy policy
    JEL: Q15 D89
    Date: 2005–11–09
  28. By: Sarbajit Chaudhuri
    Abstract: The paper provides a theory of interest rates determination in the informal credit market in backward agriculture highlighting the interactions between two informal sector lenders (a professional moneylender and a trader-interlocker) and explains the prevalence of different interest rates in the rural credit market. The trader and the moneylender play a non-cooperative game in choosing the extent of interlinkage and the non-interlinked informal interest rate, respectively. In the interlinked credit-product contract, the trader offers the interlockees a product price equal to the open market price and his entire surplus comes from his activities in the credit market. These results are completely opposite to those found in the existing literature on interlinkage. A price subsidy policy reduces the extent of interlinkage chosen by the trader while a credit subsidy policy may raise it. Besides, the subsidy policies unequivocally raise the non- interlinked informal interest rate of the moneylender but may lower the welfare of the farmers and the agricultural productivity. In this context, an alternative credit policy of forging a vertical linkage between the formal and informal credit markets has been considered. It has been found that a credit subsidy policy under the new system is able to raise the agricultural productivity and improve the welfare of the farmers by ameliorating their borrowing terms in the credit market.
    Keywords: Trader, Moneylender, Formal credit, Informal credit, Interlinkage, Interest rate, Nash equilibrium, Subsidy policy, Vertical linkage
    JEL: Q14 D89
    Date: 2005–11–09

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