An Assignment On Necessity of Resource Mobilization through Financial System for Social Welfare Maximization

Dr. M. A. Baqui Khalily

Professor

Submitted To
Department of Finance University of Dhaka

Submitted By:
Md. Hasan Ullah Roll No: 15-119

Date of Submission: 4th February, 2012 Department of Finance University of Dhaka

We cannot do anything without money. For economic development, money or finance is a necessary condition. In addition to the contribution in capital market and corporate finance, economic development is also a crucial role of finance in developing country. Finance can add value for economic development subject to the following two conditions: 1. Mobilization of resources, and 2. Effective use of resources.

Mobilization of resources
Economy will not better off or the society cannot increase its welfare if resources are unutilized resulting from not mobilizing the resources to the financial system. It is necessary to transfer the resources from surplus unit to deficit unit. To understand the necessity of resource mobilization, we will see here three alternative cases stated below: Case 1: No Formal & Informal Financial Market Exists In that case, we assume that there has no formal even informal financial market in the economy. So, individuals have to self finance for their investment demand. There has no way of resource mobilization.

Figure C1.1: Self Finance with no Resource Mobilization Option In the figure C1.1, left side and right side are showing the resources available for poor people (deficit unit) and rich people (surplus unit) respectively.

Here, = Resources available to rich people = Resources available to poor people = Investment returns to rich people from self-finance = Investment returns to poor people from self-finance As we can see, by suing all available resources of & return respectively. & rich people & poor people are getting

Since, poor people have more stepper investment demand curve than rich people, so poor people have higher marginal productivity of resources. So, our outcomes are: [Since, investment demand is downward slopping] > [MPP = Marginal Physical Product. Poor people have more stepper investment demand curve] 3. > [TR = Total Resources. Rich people have more available resources] 4. > [VTR = Price *Total Resources] Conclusion: Efficiency requires that, resources should be transferred to the poor people from the rich people until marginal productivity of resources of poor people equals to marginal productivity of resources of rich people. But we can see that resources are not mobilized as resources are tied up in the rich people with lower marginal productivity, so resources are underutilized. Case 2: Resources Mobilization through Informal Credit Market Underutilization of resources provides us the rational for resources mobilization. Now we assume that, there exists informal credit market through which resources are transferred from surplus unit to deficit unit. We can see this issue in the following figure: 1. 2. >

Figure C2.1: Informal Credit Market

As we can see that, surplus unit transfers funds to the deficit unit and earn interest on the fund. Since this is an informal credit market, so deficit unit has to search for a surplus unit who is willing to give deficit unit necessary fund. So, deficit unit will incur a transaction cost for this search in addition to interest for the borrowing. If deficit unit needs to collect fund from more than one surplus unit, than this transaction costs would hike. Deficit units return after borrowing will be return from self finance less interest and transaction cost. Like deficit unit, surplus unit will also incur a transaction cost to understand the credit worthiness of the borrower for ensuring the safety of the lending fund. So, surplus units return after lending fund will be return from self finance plus return from the lending less the transaction cost. We can see these from the following figure:

Figure C2.2: Resources Mobilization through Informal Credit Market Here, = Resources available to rich people = Resources available to poor people = Investment returns to rich people from self-finance = Investment returns to poor people from self-finance B L = Borrowing by poor people = Credit provided by rich people = Interest rate paid by the borrower

= Interest rate received by the lender = Transaction costs for borrower = Transaction cost for lender Surplus unit will provide lend to the deficit unit if the net gain of the surplus unit from the lending is positive. Total inflow for lender from lending = (1 + i- ) * Loan Total outflow for lender from lending = So, Net Gain for Lender = (1+i- ) * Loan Or, Net Gain for Lender = (i- )*Loan And, Lender will lend to the poor people if, (i- )*Loan > 0. Total inflow/Gross revenue for borrower = Total outflow for borrower from borrowing = (1 + i + So, Net Gain for Borrower = And, Borrower will borrow if, dr - (1 + i + dr - (1 + i + dr ) * Loan ) * Loan ) * Loan > 0. dr dr

Efficiency requires that, transfer of resources from surplus units to deficit unit will be socially desirable if Net Gain of Borrower is greater than the Net Gain of Lender. That is, dr - (1 + i + ) * Loan > (i- )*Loan.

If this condition is met, then resources mobilization would increase the social welfare. Conclusion: So far we have seen that, if certain conditions are met, then resources mobilization from surplus unit to deficit unit through informal credit market would increase the social welfare. But there are some obstacles for informal credit market such as: 1. Limited Fund: Lenders give loan out of his own resources. He/ She cannot take deposits from other. So there has limited fund available for lending. 2. High Transaction Cost: Both borrowers and lenders incur high transaction cost. If borrowers have to take loan from multiple lenders, then this cost would hike. 3. High Cost of Fund: Since resources are limited and informal credit consists high default risk, borrowers face high cost of fund.

Case 3: Formal Credit Market for Resources Mobilization Resources mobilization through informal credit market gives us the option to increase social welfare under certain conditions. But the problems of informal credit market force us to think about alternative option and this alternative option can be the formal credit market. Now we assume that there exists formal credit market for resources mobilization from surplus unit to deficit unit.

Figure C3.1: Formal Credit Market In a formal credit market, there exists a third party financial intermediary in addition to deficit unit and surplus unit. Surplus units deposit surplus funds to the financial intermediary and receive interest on deposits. Unlike informal credit market, the surplus units face high security and no transaction cost for their fund. So their interest on deposits is below than the interest they would receive if their exists informal credit market. Nevertheless, surplus units accept this because of high security of their fund. After deposits the return of surplus unit will be the return from the self-finance and interest on deposits. Deficit units take loan from financial intermediary and provide interest on loan to the financial intermediary. Unlike informal credit market, deficit units provide lower interest rate on loan due to the high competition in the formal credit market and regulation and has no transaction cost. So their return from investment after borrowing from formal credit market will be return from selffinance less interest on loan. We can see all these issues from the following graph:

Figure C3.2: Resources Mobilization through Formal Credit Market Here, = Resources available to rich people = Resources available to poor people = Investment returns to rich people from self-finance = Investment returns to poor people from self-finance B D = Borrowing by poor people from financial intermediary = Deposits by rich people in financial intermediary = Interest rate paid by the borrower to the financial intermediary = Interest rate received by the lender from financial intermediary Surplus units will deposits funds to the financial intermediary if the net gain of surplus units is positive from deposits. Total inflow for surplus units from deposits = (1 + Total outflow for surplus units by deposits = So, Net Gain for surplus units = (1 + Or, Net Gain for surplus units = ) * Deposits ) * Deposits dr dr

* Deposits.

And surplus units will deposits fund to the financial intermediary if , * Deposits.> 0. Gross Revenue for borrower by borrowing from financial intermediary = Total outflow for borrower by borrowing from financial intermediary = (1 + So, Net Gain for Borrower = dr - (1 + ) * Loan ) * Loan dr

And, Borrower will borrow from financial intermediary if, dr - (1 + ) * Loan > 0.

Efficiency requires that, transfer of resources from surplus units to deficit unit will be socially desirable if Net Gain of Borrower is greater than the Net Gain of Depositors. That is, dr - (1 + ) * Loan > * Deposits.

Conclusion: Both informal and formal credit market will increase the social welfare by mobilizing the resources from surplus units to deficit units under certain conditions. But formal credit market has some comparative advantage over informal credit market which provides us the rational for the existence of formal credit market such as: 1. Availability of resources: Not only lenders but also the small depositors deposit fund in the financial intermediary (Ex-Commercial Bank). So, it solves the fund crisis problem in the informal credit market. 2. Time saving: Borrowers need not search for lender and lenders also need not search for borrower. So it saves the time for both borrowers and lenders. 3. Low transaction cost: Since borrowers and lenders do not search one another they do not incur any transaction cost. Only financial intermediaries incur the transaction cost and they are specialized on minimizing the transaction cost. Transaction cost is low. 4. Low cost of fund: Since lenders get the guarantee about their loan repayment from financial intermediaries, borrowers incur low cost of fund as a consequence of low interest rate charge by the lenders. Both formal and informal credit market can increase the social welfare by mobilizing the resources from surplus units to deficit units. But formal credit market is optimal for solving the problems of informal credit market.