Lending Without Access to Collateral - A Theory of Microloan Borrowing Rates & Defaults

This paper attempts to develop a formal model for understanding the determination of borrowing rates and default rates in microloans, keeping in mind their dependence on various features of micorloan contracts. The paper examines the value of designing a loan contract, which combines an insurance feature by collecting higher payments in good states and lower amounts in bad states. It also attempts to understand the relative importance of lender monitoring efforts such as punishment, maturity structure of the loan and peer monitoring on the loan rates. The paper analyzes lenders attempts to enforce the loan contract and seeks to find the right combination of variables that can lower default risk and simultaneously provide lower interest rates to the borrower. Findings indicate that:

• Peer monitoring, combined with limited monitoring by lenders, is sufficient to reduce default probability to acceptable levels, given that there is a credible punishment cost;
• Excessive monitoring by lenders increases cost of borrowing, and might lead to non-participation by borrowers;
• As the loan size increases, the probability of default increases, and the loan rates dramatically increase, unless the maturity of the loans is increased.