We develop a model of lending and borrowing in markets where the lender has no access to physical collateral and where the borrower is heavily capital constrained. Our model of micro loans, which incorporates a) the absence of access to physical collateral, b) peer monitoring, c) threat of punishment upon default, and d) costly monitoring by lenders is used to determine the equilibrium borrowing rates. Monitoring by lenders is shown to be critical for an equilibrium to exist in our model if the maturity of the loan is too long. On the other hand, with short maturity loans, excessive monitoring is shown to be counterproductive. Monitoring plays a dual role: on the one hand, monitoring by lenders lowers the borrowing group?s ability to divert the loan for non-productive uses, but it increases the administrative costs of the loan; this increases the borrowing rate and consequently the probability of default. The manner in which the loan rates and the range of equilibria depend on the monitoring costs, joint-liability provisions and punishment technology is characterized when the borrowing group optimally chooses the timing of default to maximize the group?s value. Increases in the cost of funding of lenders is shown to result in disproportionately larger increases in the borrowing rates, at high rates of interest. Finally, cetaris paribus, an increase in the size of the loan typically leads to higher default probability.
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Cheung, Sam, and M. Suresh Sundaresan. "Lending Without Access to Collateral: A Theory of Microloan Borrowing Rates." Working paper, Columbia Business School, 2006.
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