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

We study borrowers’ optimal 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) can be enforced by the threat of severing social ties which hurts both the borrower and the lender, while formal loans (e.g., from banks) are enforced by requiring collateral. We show that in this setting the optimal informal loan contract features zero interest rate and requires no physical collateral. In contrast, formal loans charge positive interest and are collateral-based, making them a priori less attractive to borrowers. At the same time, physical collateral is divisible, unlike the social capital pledged in informal credit. Default on formal loans is thus less costly than default on informal loans. Therefore, borrowers optimally choose formal credit for riskier (and larger) loans while informal credit is used for small investments and projects with zero or low default risk. Empirical results from a survey of rural Thai households are consistent with the predicted pattern of formal versus informal credit. ∗We wish to thank Tim Besley, Andreas Madestam, Per Krussel, Torsten Persson, as well as various participants of IIES seminar at Stockholm, the 2014 CIFAR meeting and the 2012 CEA meetings for helpful comments and discussions. Special credit goes to Igor Livshits for his early contributions to the theory. We also thank Tenzin Yindok for excellent research assistance. Kessler wishes to acknowledge financial support from the Canadian Institute for Advanced Research (CIFAR). Karaivanov is grateful for financial support from the Social Sciences and Humanities Research Council of Canada. The usual disclaimer applies.