Corruption, default and optimal credit in welfare programs

Abstract

In this paper we present a dynamic model of subsidized credit provision to examine how asymmetric information exacerbates ine ciency caused by corruption. Though designed to empower the underprivileged, the fate of such credit programs largely depends on the e ciency of the credit delivery system. Corruption often erodes this e ciency. Nevertheless, when a corrupt loan o cial and a borrower interact with symmetric information, credit terms can be so designed that corruption will a ect only the size of the surplus, but not repayment. With private information on the borrower's productivity this result changes. The corrupt loan o cial may induce the low productivity borrower to default, mainly because of high revelation costs. The government can improve the repayment rate, but will have to under-provide the rst period loan. On the other hand it can permit default by the low productivity borrower, and maintain a higher credit level. The second option may sometimes be preferred. This ine cient outcome is caused by two factors - informational ratchet e ects and countervailing incentives, which are commonly present in many agency relationships.