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

Alexander Karaivanov and Anke Kessler

Discussion Papers from Department of Economics, Simon Fraser University

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.

Keywords: Informal credit; family loans; social capital; peer-to-peer lending; microfinance. (search for similar items in EconPapers)
JEL-codes: D19 D64 G21 O12 O16 O17 (search for similar items in EconPapers)
Pages: 33
Date: 2013-05, Revised 2013-04
New Economics Papers: this item is included in nep-ban, nep-iue, nep-mfd and nep-soc
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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