Question

List and define the types of potential capital market imperfections. Discuss which specific market imperfections or failures Community Reinvestment Acts (CRA) was designed to address in theory and practice. Has CRA been a success and why?

Giving examples compare and contrast debt versus equity financing. Organo grocery store, the only grocery store that only specializes solely on Organic foods in Victoria County, has been successfully operating in Victoria Texas in their 5,000 Square foot store. Due to increased demand for their organic produce, they have decided to open another 5,000 square organic grocery store in the neighboring city of Cuero. They have already identified a location and are looking for financing to acquire the lease for property, finance new building renovations, and acquire equipment and inventory. Which method of financing would you advise him and why?

Answer 1

The types of potential cap;ital market imperfections can be listed and explained as follows:-

1. Asymmetric Information :- The information asymmetry that occurs between the lenders and borrowers can be further subdivided into two parts

a) Adverse Selection : This occurs when the lender (individuals or banks) remains unable to distinguish between borrowers with good credit ratings (low credit risk) and bad credit ratings ( high credit risk) .

b) Moral Hazard : When the lender remains incompletely informed about the type of behavior of the borrower . Similar to Agency problems, the borrower often tends to switch to riskier projects for greater expected return after having posed to take loans for a relatively safe project.

2. Limited commitment imperfections : - This problem occurs when the borrower defaults on the loan ex-post, i.e., after the amount has been lent . This occurs even in cases where all the legal procedures were undertaken while sanctioning the loan. This is because often the enforcement costs to ensure loan payback are too high and borrowers are never able to recover their full amount. This can be referred to as default risk.

3. Incomplete credit market : Same or similar credit funds can often be valued differently at different parts of the world. Hence it is often the case that the interest rate for such credits vary thus making credit a non- homogeneous good. In a perfect capital market every party would have exchanged funds at an uniform market rate of interest. However the case is rarely so.

As per the outline of the Community Reinvestment act , it is clear that the act had been taken up in order to address the problems of Credit Rationing that lenders resort to under the existence of Limited Commitment ( capital market Imperfection). Because of the default risk , often lenders cut the supply of loans to an extent, thus rationing the credit market, this creates and excess demand for loans, thus pushing up the interest rates. However the middle or low income individuals and firms often cannot afford such capital costs thus getting excluded, CRA tries to address this problem.

The CRA is has been known to ensure for more equal and efficient redistribution of credit. Post its 2005 revisions, CRA has gone beyond the metropolitan cities , outreaching to the more middle income geographies including the more credit deprived and undeserved parts of the economy. Though in the light on the financial and mortgage crisis of the previous decade it had been subjected to some criticisms which claimed CRA to be promoting bad loans. However many government acknowledged analysis do support the claim of mixed effects of CRA, the results find that CRA has helped promote higher home-ownership rates and even fared in influencing lower crime rates among the low - income CRA administered areas . However claims are high that such positive changes may be absolutely a result of changing technology and market structure. On the positive side, a study, conducted by a professor at the University of Southern California and a professor at the University of Delaware, confirms that banks are eager to improve their CRA ratings which is an effective evidence against CRA promoting bad loans.

Debt Financing is refers to financing the operations of a business firm by taking loans from financial institutions in exchange for repayment plus an interest amount . This allows the borrowing entity to retain the entire owner of their business or project. A company when finances its operations by taking loans by issuing bonds or direct loans it goes for debt financing.

Equity Financing refers to raising capital through selling a percentage of ownership and a share in profit of the business. The owner of the business is not liable to return any amount .

Debt financing can be undertaken by small firms whereas equity financing is not possible until either the business ids growing and very dynamic or the firm is already operating on a dynamic scale.

Organo Grocery should opt for Debt Financing . This is because since their business is running good they are likely to be identified with high credit ratings and easily loan the amount they are in need for. Given that their business strategy is working their default risk shall be low, also if they do fail in floating their new store they can claim default and rescue themselves from complete loss of the total amount if they are operating under limited liability. However, if they still choose to opt for equity financing it has to be kept in mind that raising capital through selling shares is costly in itself and also, that if the new store is successful enough they shall be probably paying out a part of their profit to the partners and given the scale of their operations that might not be profitable overall.