The Use of Collateral in Formal and Informal Lending

We offer a new test of the ex ante theory of collateral. Theory states that lenders rely less on collateral if they have better information about borrowers. We test this by contrasting the use of collateral between formal and – better informed – informal lenders in a developing financial market. Indeed, formal lenders rely about 40% more often on collateral than informal lenders, controlling for conventional determinants of collateral. Moreover, having better information about borrowers has implications within lender groups: formal lenders rely less on collateral with longer borrower-relationship and informal lenders rely less on collateral with shorter distance to the borrower.

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