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A Friend in Need is a Friend Indeed: Theory and Evidence on the (Dis)Advantages of Informal Loans

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Abstract

We develop a model to study the choice between formal and informal sources of credit in a setting with strategic default due to limited enforcement. Informal loans (e.g., from friends or relatives) are enforced by the threat of both parties losing the friendship relation. In contrast, formal loans (e.g., from banks) can only be enforced via collateral requirement. We show that the optimal informal loan contract features zero interest rate and zero physical collateral requirement. In contrast, formal loans always charge positive interest and require collateral. Borrowers are more likely to choose informal loans for small investment needs, and for loans with no or low default risk. Riskier loans, up to a limit, are optimally taken from formal sources since physical collateral, unlike social collateral is divisible, and defaulting with a bank is thus less costly than defaulting with a friend. Very risky loans, in contrast, can only be financed by informal sources due to insufficient collateral. Because default with social capital is relatively costly, however, personal loans also imply a limited growth potential. Empirical results from a cross section of 2880 Thai households are consistent with the predicted pattern of formal versus informal credit.

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Bibliographic Info

Paper provided by Department of Economics, Simon Fraser University in its series Discussion Papers with number dp13-03.

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Length: 33
Date of creation: May 2013
Date of revision: Apr 2013
Handle: RePEc:sfu:sfudps:dp13-03

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Keywords: Informal credit; family loans; social capital; peer-to-peer lending; microfinance.;

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References

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  1. Jain, Sanjay, 1999. "Symbiosis vs. crowding-out: the interaction of formal and informal credit markets in developing countries," Journal of Development Economics, Elsevier, Elsevier, vol. 59(2), pages 419-444, August.
  2. Kochar, Anjini, 1997. "An empirical investigation of rationing constraints in rural credit markets in India," Journal of Development Economics, Elsevier, Elsevier, vol. 53(2), pages 339-371, August.
  3. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, American Economic Association, vol. 71(3), pages 393-410, June.
  4. Giné, Xavier, 2011. "Access to capital in rural Thailand: An estimated model of formal vs. informal credit," Journal of Development Economics, Elsevier, Elsevier, vol. 96(1), pages 16-29, September.
  5. Timothy Besley, 1995. "Nonmarket Institutions for Credit and Risk Sharing in Low-Income Countries," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 9(3), pages 115-127, Summer.
  6. Guirkinger, Catherine, 2008. "Understanding the Coexistence of Formal and Informal Credit Markets in Piura, Peru," World Development, Elsevier, Elsevier, vol. 36(8), pages 1436-1452, August.
  7. Abhijit V. Banerjee & Esther Duflo, 2007. "The Economic Lives of the Poor," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 21(1), pages 141-168, Winter.
  8. Besley, Timothy & Coate, Stephen, 1995. "Group lending, repayment incentives and social collateral," Journal of Development Economics, Elsevier, Elsevier, vol. 46(1), pages 1-18, February.
  9. Braverman, Avishay & Stiglitz, Joseph E, 1982. "Sharecropping and the Interlinking of Agrarian Markets," American Economic Review, American Economic Association, American Economic Association, vol. 72(4), pages 695-715, September.
  10. Ghatak, Maitreesh, 1999. "Group lending, local information and peer selection," Journal of Development Economics, Elsevier, Elsevier, vol. 60(1), pages 27-50, October.
  11. Mansuri, Ghazala, 2007. "Credit layering in informal financial markets," Journal of Development Economics, Elsevier, Elsevier, vol. 84(2), pages 715-730, November.
  12. Townsend, Robert M, 1995. "Financial Systems in Northern Thai Villages," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 110(4), pages 1011-46, November.
  13. Turvey, Calum G. & Kong, Rong, 2010. "Informal lending amongst friends and relatives: Can microcredit compete in rural China?," China Economic Review, Elsevier, Elsevier, vol. 21(4), pages 544-556, December.
  14. Mikkel Barslund & Finn Tarp, 2007. "Formal and Informal Rural Credit in Four Provinces of Vietnam," Discussion Papers, University of Copenhagen. Department of Economics 07-07, University of Copenhagen. Department of Economics.
  15. Stephen R. Boucher & Michael R. Carter & Catherine Guirkinger, 2008. "Risk Rationing and Wealth Effects in Credit Markets: Theory and Implications for Agricultural Development," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, Agricultural and Applied Economics Association, vol. 90(2), pages 409-423.
  16. Bose, Pinaki, 1998. "Formal-informal sector interaction in rural credit markets," Journal of Development Economics, Elsevier, Elsevier, vol. 56(2), pages 265-280, August.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. When to borrow from friends
    by Economic Logician in Economic Logic on 2013-08-12 15:09:00
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Cited by:
  1. Carmen Kislat & Lukas Menkhoff & Doris Neuberger, 2013. "The Use of Collateral in Formal and Informal Lending," Kiel Working Papers, Kiel Institute for the World Economy 1879, Kiel Institute for the World Economy.

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