IED Discussion Paper Series No.93

We study the problem of loan enforcement in an informal credit market where credit histories of borrowers are not available to lenders, raising the possibility of serial default. We show that if there is critical minimum proportion of natural defaulters in the populatin, then there exists an unique equilibrium constituted by certain simple "behavior rules" for lenders and borrowers. This equilibrium always takes the form that lenders advance limited amount of credit (possibly at higher interest rates) to first time borrowers; credit limits are relaxed and the relationship continued, conditional on repayment. We call this phenomenon micro-rationing. We also introduce the possibility of macro-rationing - at every date, the exclusion of some borrowers from any source of credit (similar to involuntary unemployment, a la Shapiro and Stiglitz (1984)). We observe (i) if both kinds of rationing are allowed, an unique equilibrium in simple, stationary strategies always exists (ii) micro-rationing is always rpesent in equilibrium (iii) macro-rationing arises if the proportion of natural defaulters in the market is below a certain threshold. Some comparative static properties of changes in the composition of borrowers are also derived. Finally, we show that if lenders had the option of privately collecting information on the credit histories of new clients at a cost, multiple equilibria could arise for intermediate values of such costs. We thus interpret limited client information in informal credit markets as a possible outcome of coordination failure among moneylenders.

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