“Rosca Meets Financial Market” by Rongzhu Ke
Chinese University of Hong Kong
University of Pennsylvania
Rotating Savings and Credit Association (Rosca) is an important informal financial institution in many parts of the world. Existing models of Roscas assume that their participants do not have alternative financial devices. However, in reality, evidences show that direct borrowing and lending may co-exist with Rosca. Then, what is the advantage (if any) of Rosca over direct borrowing and lending? In this paper, we develop a model under which risk-averse participants pool their privately known income shocks to investigate the interesting interactions between Roscas and the formal credit market. We first consider two benchmark cases of Roscas, without access to a formal financial market, and with access to a perfect credit market (no interest rate gap between borrowing and lending). In the first benchmark, we show that a bidding Rosca is ex ante welfare improving (but may not be interim individually rational) when the size is optimally chosen. In the second benchmark, we show that Rosca is not even ex ante beneficial. However, in between, if there is an imperfect credit market with interest rate gap, a bidding Rosca is welfare improving (in a stronger sense, interim individually rational) because Rosca participants use both financial market and Rosca to smooth the income shocks. Therefore, the social welfare may not monotonically increase with the perfectness of the credit market. Finally, we show that a Rosca with some social norm could still be ex ante beneficial even if the interest rate gap disappears.