Formal-informal sector interaction in rural credit markets

The majority of small cultivators in the less developed countries are not regarded as credit-worthy by the formal sector financial institutions, and are forced to borrow from the moneylenders in the informal credit market. This paper shows that when such borrowers differ in their likelihood of default, and the moneylenders are asymmetrically informed about the client-specific degree of risk, the policy of providing cheap credit through the formal sector can generate adverse 'composition effects' which worsen the terms of credit and the availability of loans in the informal sector. (C) 1998 Elsevier Science B.V. All rights reserved.