Interactions of Informal and Formal Agents in South Asian Rural Credit Markets John Adams, Hans-Peter Brunner, and Frank Raymond* Abstract The paper provides a realistic explanation for the persistently large loan costs in the informal and formal credit markets of South Asia. In the presence of the adverse selection problems that arise from information asymmetries and discrepancies in credit services, price competition in somewhat differentiated products is sufficient to generate the high interest rate convergence observed in Nepalese credit markets. Most prior literature emphasizes collusion as the cause and leads to ineffective entry-oriented policy prescriptions.The new interpretation stresses the need to reduce information asymmetries, product differentiation, and moral hazard risks, while widening the spatial orbits of agent competition. 1. Introduction Agricultural development in South Asia continues to be hampered by capital market deficiencies. For over a century official policy has been directed at replacing traditional moneylenders with formal institutions such as cooperatives, rural development banks, and commercial bank branches. After many failures, it is becoming clear that interac- tions between informal and formal agents, and with their clients, are intriguingly complex. Evidence from Nepal indicates that informal lenders have remained domi- nant in rural credit markets, while, in the formal sector, total loan charges, including interest, transactions costs, and corrupt side payments, have stayed high. These rigidities suggest the possibility of tacit or overt collusion, but may possibly imply deep-seated informational and cost or risk factors. Field experience indicates that three related problems persist. Total borrower loan costs in the formal sector converge upwards to the rates offered by local informal lenders. State-sponsored rural credit institutions exhibit unacceptably high loan default rates.Well-intentioned microfinance initiatives require periodic transfusions to sustain their operations, while allegedly rapacious moneylenders continue to thrive. Recent literature attempts to address the common root of the persistence of high interest rates and the survival of the informal creditors.The prevalent conclusion is that when lenders are few, they can calculate that each one is better off with cooperation. As players, they move to an equilibrium under a collusive agreement, albeit without express communication (Caselli, 1997; Hulme and Mosley, 1996; Kapur, 1992; Bell, 1990). Certainly, pure economic profits could result from tacit collusion between the formal and informal rural credit agents. Yet, oligopolistic collusion is inherently unstable, even when there is overt collaboration (Green and Porter; 1984; Abreu et al., 1986; Review of Development Economics, 7(3), 431–444, 2003 *Adams: University of Virginia, Charlottesville, VA 22901, USA. Tel: 540-785-1798; Fax: 540-785-1853; E-mail: JQA3@msn.com. Brunner: Asian Development Bank, 6 ADB Avenue, Mandaluyong City 0980, PO Box 789, Manila, Philippines. Tel: (63-2)-632-4159; Fax: (63-2)-632-5016; E-mail: hbrunner@adb.org. Raymond: Bellarmine University, Louisville, KY 40205, USA. Tel: 502-452-8487; Fax: 452-8013; E-mail: fraymond@bellarmine.edu. The authors thank anonymous referees for their perspicacity, but are solely responsible for the final contents and do not speak for their institutional affiliates. A longer version of this paper, which includes some helpful figures, may be found at www.neat.net.np. © Blackwell Publishing Ltd 2003, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA