Monday, August 12, 2013

When to borrow from friends

When should I borrow from friends or from banks? With friends, I would typically get a lower interest rate, but I could risk losing a dear friendship. With banks, I pay more in interest and have to bring collateral, but I can walk away with relatively little damage. There are some situations where one should be preferred to the other.

Alexander Karaivanov and Anke Kessler study this question in the context of a world where borrowers can default strategically and there is limited enforcement of loan contracts. First they show that the optimal informal loan (from friends or relatives) features zero interest rate and zero collateral. This is because friendship is an efficient enforcement mechanism. That would typically happen with smaller, less risky loans. Then Karaivanov and Kessler show that if there is sufficient risk in the loan, one should go for a formal loan. The reason is that the collateral is divisible. In an informal loan, you either keep or lose the friendship. With a formal loan, you may still keep part of the collateral if things go bad. Using household data from Thailand, they find that their model lines up nicely with the data.

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