Informal Lending and Entrepreneurship
46 Pages Posted: 21 Dec 2017
Date Written: December 18, 2017
How does the informal economy affect financial inclusion and entrepreneurial activity of consumers? We investigate the impact of informal lending on the types and terms of contracts offered by formal lenders, considering factors that facilitate informal lending activity such as social ties between consumers. The density of the connections between consumers represents the degree to which those with and without wealth mix, indirectly capturing the degree of inequality in a society. We develop a model which relates the density of social connections to the availability of informal lending activity. We show that a low to moderate degree of informal activity in a market can help unwealthy entrepreneurs because it motivates the bank to compete by cutting down the interest rate of unsecured loans offered to these consumers. In turn, the bank faces an overinvestment problem when financial inclusion is higher. As informal borrowing opportunities increase further, lenders’ benefit from increased access to credit diminishes. It earns higher rents by increasing the rates on wealthy low-risk consumers who can informally lend to their social contacts. As a consequence, the overinvestment problem is replaced by an underinvestment problem and creditworthy entrepreneurs are deprived of loans from banks. We argue that although the entrepreneurial investment shrinks, only those projects with the best return are awarded financing, implying that the average investment in the market is now more attractive.
Keywords: informal lending, entrepreneurship
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