Rural and urban microfinance credit markets are characterised by features that cannot adequately be explained by perfect competition or monopoly theory. For instance, informal and formal lenders coexist even though formal lenders charge substantially lower interest rates. The price of credit (interest rate) may also not equilibrate the supply of and demand for credit. Instead it is observed that some loan applicants receive loans while others receive less than the desired amount, or no credit at all (they are quantity or non-price credit-rationed), although they are informationally indistinguishable (Baltensperger, 1978; Stiglitz and Weiss, 1981; Carter, 1988). The involvement of formal commercial lenders in rural financial markets
tends to be limited to loans that are well collateralised by assets with secure and transferable property rights.
These observations about rural and urban microfinance markets result from the agency relationship that exists between lenders (principals) and borrowers (agents). Principal-agent theory describes the relationship between economic agents where the principal wants to induce the agent to take a specific action. In loan contracts, the lender contracts with a borrower to productively utilise and repay the borrowed funds at a future point in time (Barry et al., 1995: 185 - 212). The challenge for the principal is to induce the agent to take the best actions that are consistent with the principal's objectives, by building incentives into the contract 01arian, 1996).
Information asymmetries (differences) arise in loan contracts since borrowers (agents) have private information about their risk level (quality), distribution of investment returns, level of effort exerted and the states of nature that affect those actions (Kotowitz, 1987; Besley, 1994). Two important problems arise from information asymmetries, namely adverse selection and moral hazard. Adverse selection occurs when lenders do not know particular characteristics of loan applicants or are unable to adequately assess the distribution of returns of investments available to loan applicants. Loans may, therefore, be granted to both high- and low-risk borrowers (Wilson, 1987). In the presence of adverse selection, the challenge for the lender is to separate high and low risk borrowers. This can be done by investing in screening technologies, or by designing contracts that encourage agents to reveal their type 01arian, 1996).
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Moral hazard occurs when there are actions that borrowers can take on during the term of the loan contract (adopting a riskier action that originally anticipated by the lender) in maximising their own utility, that are detrimental to the lender (Kotowitz, 1987). Moral hazard results because the principal cannot costlessly and accurately observe the level of effort exerted by the agent. All that can be observed is the outcome of the project. The principal does not always know whether this outcome is as a result of agent effort or external factors beyond the control of the agent. Rodriguez-Meza (2000) refers to this as ex post contractual risk. To mitigate against such risk, the principal must design a contract that will induce the agent to take the desired level of action, ex ante, subject to the constraints imposed by the agent's optimising behaviour CVarian, 1996).
Agents face two constraints in their optimising behaviour. The first is that the agent may have another opportunity available that provides some reservation utility. The principal must ensure that the agent receives at least this reservation utility in the contract. This is referred to as the participation constraint. Second, a contract must motivate the agent to align hislher interests with that of the principal. This is the incentive compatibility constraint (Varian, 1996). Under symmetric information, the principal will always be able to offer a contract such that the agent exerts maximum effort. In the presence of asymmetric information about the agent's level of effort and reservation utility, the challenge for the principal is to design a contract that induces the desired level of effort, subject to the participation constraint. This involves passing some of the risk of the project outcome on to the agent such that the principal does not bear all of the risk of a failed outcome, and thus maintains the right incentives in the contract CVarian, 1996).
Loan contracts are thus inherently risky, with the risk being a function of the level of information possessed by the two contracting parties, and available incentive and enforcement mechanisms (Hoff and Stiglitz, 1990). Lenders may incur considerable agency costs in structuring, administering and enforcing loan contracts to better align borrower goals with those of the lender, resolving problems associated with informational deficiencies, and dealing with contingencies during the loan term (Barry et al., 1995: 185 - 212). Given the risks, lenders adjust contract terms. This may result in some, particularly small, borrowers being rationed out of the formal credit market, since formal lenders have a distinct informational disadvantage to informal lenders and may find contract enforcement extremely costly when operating in microfmance markets (Gonzalez-Vega, 1984; Carter, 1988).
In addition, the financial technologies used by lenders may impose high transaction costs on borrowers. Small rural and urban borrowers may thus opt not to borrow from formal financial intermediaries (voluntary price credit-rationing), while lenders may opt not to operate in these fmancial markets since high contracting costs negatively influence viability. Therefore, on a policy level, these informational, incentive, enforcement and transaction cost issues need to be addressed before formal credit can be successfully extended to rural and urban borrowers.
The following sections outline the consequences of asymmetric information in credit markets, and highlight the need for cost effective screening, incentive and enforcement mechanisms.