Imperfect information and financial liberalization in LDCs

Abstract

This thesis examines the interest rate, market entry and credit decisions which banks are expected to make following financial liberalization. It uses analytic tools from information economics and industrial organization theory to consider the policy implications of behaviour which responds to the constraints of imperfect information. The financial markets of the Caribbean Commonwealth supply the stylized facts which inform the analysis. Chapter 1 introduces the topics treated. The financial liberalization hypothesis is based on the 1973 works of McKinnon and Shaw. Chapter 2 describes their characterization of market fundamentals and behaviour in LDCs. It discusses the descriptions of equilibrium, and the welfare implications of these equilibria, in models which analyze economies with similar fundamentals. Chapter 3 derives stylized facts from the descriptions of the economic institutions and financial systems of the four Caribbean countries whose banking behaviour we model. Chapter 4 analyzes deposit rate determination by banks in the long-run equilibrium of a search market. It posits that in long-run equilibrium depositors find it costly to switch banks because doing so requires that they forego improved service at their current banks. The inelastic deposit supply which results from these switching costs implies that monopsonistic deposit rates are a noncooperative equilibrium. It is argued that this facilitates tacit collusion among banks and that a deposit rate floor is the appropriate policy corrective. Chapter 5 argues that the enhancement of intermediation service responsible for depositor switching costs reflects the information banks acquire about customers and their ability to offer suitably tailored service. Chapter 6 considers bank entry into a market where established customers of certain value have switching costs. Entering banks attract new customers of lower expected value. If new banks are therefore unable to generate sufficient revenue to cover their fixed costs, they exit. This chapter argues that liberal entry policy is not sufficient to ensure competition. Chapter 7 develops a simple model of bank screening by loan size in one sector of an economy. It finds a sequential equilibrium in which low-risk borrowers , self-select by the choice of contracts with a loan size below that they demand at the interest rate for their risk class. In Chapter 8 the partial equilibrium model of Chapter 7 is embedded in a general equilibrium framework to demonstrate that the market equilibrium is not constrained Pareto efficient. It argues that subsidizing the highest interest rates will improve loan allocation while maintaining the separation induced by private contracts. Chapter 9 summarizes the main results and conclusions of the thesis