Informal Credit in Village Economies: Contract Duration with Personal and Community Enforcement

This paper provides an explanation for several important features of informal credit contracts negotiated in economies where households lack collateral, and ready access to legal authorities and formal financial institutions is absent. Our analysis highlights the choice between loans with well-defined repayment periods (fixed durations) and those that are open-ended (no duration). We argue that households negotiate fixed- duration loans only when the borrower's ability to repay is private information, and borrowers enjoy non-credit (social) exchanges with lenders that can be withdrawn to encourage loan repayment. Other differences in loan terms can be explained by the exclusive availability of collective loan enforcement to lenders and borrowers residing in the same community. Drawing on a unique household-level survey, we find empirical support for our model's explanation for duration and the size of loans, as well as borrower's repayment behavior. Our analysis also highlights a negative externality among informal personal and community enforcement mechanisms whereby the availability of both mechanisms in the same village reduces the payments that can be credibly promised with either one.