Information and Enforcement in Informal Credit Markets

We study the problem of loan enforcement in an informal credit market with limited information flow. Specifically, credit histories of borrowers are not available, raising the possibility of endemic default. We show that if there is some minimum proportion of “natural defaulters” in the population, then there exists an equilibrium characterized by certain simple behavior rules for lenders and borrowers. The equilibrium is unique if certain restrictions are placed on strategies. This equilibrium takes the form that lenders must advance a “small” amount of credit (possibly at a high interest rate) to first-time borrowers. Credit limits are relaxed and the relationship is continued, conditional on repayment. We call this phenomenon microrationing. We then introduce the possibility of macro-rationing: the temporary exclusion of some borrowers from any source of credit. We show that in this case, (i) our “simple” equilibrium always exists regardless of the proportion of natural defaulters; though (ii) microrationing is always present in equilibrium, while (iii) macro-rationing arises if and only if the proportion of natural defaulters lies below a certain threshold. Finally, we show that if lenders have the option of privately collecting information on the credit histories of new clients, multiple equilibria in information collection could arise. Consequently, it is possible to interpret limited client information in informal credit markets as coordination failure among moneylenders. We thank, without implicating, Douglas Bernheim, Avner Greif, Albert Ma, Dilip Mookherjee, Robert Rosenthal and Curtis Taylor for helpful discussions. Useful comments were also received from seminar participants at Boston, Iowa State, Stanford and Texas A&M University, and the University of Rochester, UCLA and University College, London. Address all correspondence to Parikshit Ghosh, Department of Economics, University of British Columbia, Vancouver, B.C V6T 1Z1, Canada (email: [email protected]).