Financing from Family and Friends
AbstractThe constraint on informal finance is commonly taken to be high costs and limited supply. But the majority of informal investors – family and friends – is often willing to supply funds at negative returns, and yet many borrowers tap family and friends only as a last resort. We explain this paradox with a theory based on altruistic ties between the entrepreneur and his family and friends, and propose an alternative explanation of the limits of informal finance: Altruistic ties reduce agency problems in financing. But such ties also increase the entrepreneur’s aversion to failure. This makes financing from family and friends unattractive, and undermines the entrepreneur’s willingness to take risks. Altruistic ties thus constrain growth even though they relax financing constraints. We relate this insight to the limited success of group-based microfinance in generating entrepreneurial growth. Our theory underscores the value of impersonal transactions, and implies that even counterparties with social ties benefit from formal contracts and third-party intermediation. This sheds light on social-formal financial institutions, such as community funds, crowd funding, and social lending intermediaries.
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Bibliographic InfoPaper provided by Research Institute of Industrial Economics in its series Working Paper Series with number 933.
Length: 56 pages
Date of creation: 11 Oct 2012
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Informal finance; Family loans; Social ties; Altruism; Peer-to-peer lending; Small business;
Find related papers by JEL classification:
- D19 - Microeconomics - - Household Behavior - - - Other
- D64 - Microeconomics - - Welfare Economics - - - Altruism; Philanthropy
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- O16 - Economic Development, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
- O17 - Economic Development, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-10-20 (All new papers)
- NEP-ENT-2012-10-20 (Entrepreneurship)
- NEP-IUE-2012-10-20 (Informal & Underground Economics)
- NEP-MFD-2012-10-20 (Microfinance)
- NEP-SOC-2012-10-20 (Social Norms & Social Capital)
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