Modeling Loan Repayment Behavior in Developing Countries

Effective control of non-performing assets (NPAs) is critical for sustainable and healthy growth in the banking sector of any economy. In this paper we attempt to establish a possible connection between the problems of loan non-repayment in the formal credit market and credit accessibility from informal sources in India. The latter appears to flourish in many developing countries despite various government-initiated formal lending programs. Scholars often examine how poorer households become the victim of usurious interest rates charged by informal lenders and thereby lose their valuable securities. Our approach, however, suggests that the more unfavorable the terms of loan from an informal moneylender compared with a formal lending agency, the better are the chances of a borrower making a timely repayment, and thus obtaining the benefits of a formal loan on a recurring basis (which is not available in the case of default). The paper uses the National Sample Survey Organization database (59-super-th round, All India Debt and Investment Survey) to empirically examine the impact of interest rate in the informal sector on formal sector repayment. In addition to revealing a positive and significant impact of the informal sector's interest rate on the repayment of formal loans, the empirical analysis reveals a plausible negative impact of expectation regarding a loan waiver, as well as the moral hazard problem faced by formal lending agencies. Copyright 2013, Oxford University Press.