Corruption, Default and Optimal Credit in Welfare Programs

In this paper we present a dynamic model of subsidized credit provision to examine
how asymmetric information exacerbates ineciency caused by corruption. Though designed
to empower the underprivileged, the fate of such credit programs largely depends
on the eciency of the credit delivery system. Corruption often erodes this eciency.
Nevertheless, when a corrupt loan ocial and a borrower interact with symmetric information,
credit terms can be so designed that corruption will aect only the size of the
surplus, but not repayment. With private information on the borrower’s productivity
this result changes. The corrupt loan ocial 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 inecient outcome is caused by two
factors – informational ratchet eects and countervailing incentives, which are commonly
present in many agency relationships.