Repeated Lending in Informal Credit Markets with Adverse Selection and Strategic Default

The paper shows that in an infinitely repeated lending–borrowing model, where the stage game is characterized by adverse selection, borrowers who do not have access to alternative sources of credit are willing to pay a higher interest rate than those with access to such credit sources. If arbitrage cannot be ruled out, in the pooling equilibrium where some default is an equilibrium outcome, there are two possible equilibria: one with a higher interest rate than the other. It is found that the higher interest rate is paid by borrowers who value their future more identified as forward-looking borrowers, whereas the lower interest rate is paid by myopic borrowers who value their present more than the future. Also the higher interest rate equilibrium will prevail if the proportion of borrowers with greater access to alternative credit sources in the population falls below a critical level, and the lower interest rate equilibrium will prevail if it lies above the critical level. In addition, higher return from any successful venture, lower amounts of loan, higher probability of success of any project, increasing future orientation of the borrowers with greater access to alternative credit sources and lower valuation of future incomes of the lender and borrowers with no alternative credit sources reduce the market interest rate.