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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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  • Alexander Karaivanov & Anke Kessler, 2013. "A Friend in Need is a Friend Indeed: Theory and Evidence on the (Dis)Advantages of Informal Loans," Discussion Papers dp13-03, Department of Economics, Simon Fraser University, revised Apr 2013.
  • Handle: RePEc:sfu:sfudps:dp13-03
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    References listed on IDEAS

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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 20:09:00

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    Cited by:

    1. Kislat, Carmen & Menkhoff, Lukas & Neuberger, Doris, 2013. "The use of collateral in formal and informal lending," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79765, Verein für Socialpolitik / German Economic Association.
    2. Danzer, Alexander M. & Danzer, Natalia, 2016. "Pension generosity and mental wellbeing: The effect of eradicating poverty at old-age," Annual Conference 2016 (Augsburg): Demographic Change 145910, Verein für Socialpolitik / German Economic Association.

    More about this item

    Keywords

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

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • O12 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements
    • D19 - Microeconomics - - Household Behavior - - - Other
    • D64 - Microeconomics - - Welfare Economics - - - Altruism; Philanthropy; Intergenerational Transfers

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