Keeping the Little Guy Down: A Debt Trap for Informal Lending

Microcredit and other forms of informal finance have so far failed to catalyze business growth among small scale entrepreneurs in the developing world, despite their high return to capital. This prompts a re-examination of the special features of informal credit markets that cause them to operate inefficiently. We present a theory of informal lending that highlights two of these features. First, borrowers and lenders bargain not only over division of surplus but also over contractual flexibility (the ease with which the borrower can invest to grow her business). Second, when the borrower’s business becomes sufficiently large she exits the informal lending relationship and enters the formal sector – an undesirable event for her informal lender. We show that in Stationary Markov Perfect Equilibrium these two features lead to a poverty trap and study its properties. The theory facilitates reinterpretation of a number of empirical facts about microcredit: business growth resulting from microfinance is low on average but high for businesses that are already relatively large, and microlenders have experienced low demand for credit. The theory features nuanced comparative statics which provide a testable prediction and for which we establish novel empirical support. Using the Townsend Thai data and plausibly exogenous variation to the level of competition Thai money lenders face, we show that as predicted by our theory, money lenders in high competition environments impose fewer contractual restrictions on their borrowers. We discuss robustness and policy implications. ⇤Ben Roth benefitted from the NSF Graduate Research Fellowhip under Grant No. 1122374. We would like to thank Daron Acemoglu, Itai Ashlagi, Abhijit Banerjee, Vivek Bhattacharya, Ben Olken, Bill Kerr, Scott Kominers, Dorothea Kuebler, Josh Lerner, Stephanie Lo, Andrey Malenko, Roger Myerson, Ramana Nanda, Muriel Niederle, Harry Pei, Canice Prendergast, Debraj Ray, Alp Simsek, Ludwig Straub, Robert Townsend, and Georg Weizsäcker for helpful discussions. All errors are our own.