Popular opinion holds that credit enforcement which strengthens lenders’ rights to appropriate collateral in the event of default, can reduce access to credit for poorer borrowers. Economists argue otherwise, saying it enlarges the credit available by increasing lender confidence. But evidence from one study suggests the popular view may be right.
Ulf von Lilienfeld-Toal, Dilip Mookherjee and Sujata Visaria looked at India where, in the early 1990s, measures were introduced to improve the financial health of commercial banks. Debt Recovery Tribunals (DRTs) were created to speed up the recovery of debts to banks and financial institutions, a process that previously had taken many years.
Contrary to prior studies in other contexts that found credit enforcement had expanded credit, the authors found smaller borrowers were hurt by the reform. The reason for the difference, they said, was that the other studies had looked at the average borrower and not looked separately at the ieffects on smaller and wealthier borrowers. Prior studies had also assumed that banks would expand credit availability expand in response to the reform.
“The standard theoretical argument is valid when bank credit is infinitely elastic. But when the supply is inelastic, stronger enforcement of lender rights can increase interest rates and reallocate credit from poor to wealthy borrowers. This provides a rationale for the popular belief that stronger enforcement hurts poor borrowers and benefits lenders and wealthy borrowers,” they said.
The inelasticity of credit is due to banks needing to invest time and infrastructure to adjust their lending operations after reform, employ more loan officers and develop expertise and relationships. In the short run, credit cannot be expanded quickly at a constant marginal cost, so interest rates rise.
The effect of the interest rate increase is not uniform. All borrowers will now borrow less than they would have if interest rates had not risen, but since wealthy borrowers have greater assets to post as collateral, they would still expand their borrowing. In contrast, smaller borrowers could end up borrowing even less than before.
The authors show this is what happened in India after DRTs were introduced.
“Small firms in India experienced a contraction in credit and fixed assets following a reform that had strengthened banks’ ability to enforce credit contracts,” they said.
Interest rates increased significantly by 1.7 - 3.3 per cent for all categories of firms following the establishment of the DRTs. The top 25 per cent of firms increased their borrowing, fixed assets and profits. Small firms, however, had insufficient collateral to permit an expansion in credit access, so the higher interest rates resulted in less borrowing.
Bank profits also increased and they began restructuring their activities towards more lending operations in urban and metropolitan areas, where larger borrowers were located, rather than rural areas where consumers and farmers were the primary borrowers.
Even three years after the introduction of DRT’s, they found wealthy borrowers and lenders were still benefiting at the expense of smaller borrowers.
“Our results cast doubt on the general presumption that stronger lender collection rights or an expanded scope for collateral will relax credit market imperfections for most borrowers, or that aggregate efficiency and output will necessarily increase.
“Lenders were generally made better off by the stronger credit enforcement, but a large fraction of borrowers was adversely impacted. If small firms have higher marginal returns to capital, this redistribution of credit may have an adverse macroeconomic impact,” the authors said.
Their theory also suggests an adverse impact on workers but that will require further research.