Unlicensed moneylending markets: relational contracting between borrowers and guarantors

Unlicensed moneylending is when an unlicensed individual, often called loan shark, lends money to another individual. We model the unlicensed moneylending market to analyze relational contracting between borrowers and guarantors. A guarantor repeatedly decides whether to act as the guarantor for a borrower, whereas the borrower repeatedly chooses a loan shark to borrow from and determines his effort in repaying loans. We show that the borrower starts by trying different loan sharks to learn about their forcefulness in collecting repayments and eventually only trades with those who are less forceful. Inefficient suspension or termination of relationship is necessary to discipline the borrower's behavior when the parties are still uncertain about the loan sharks' forcefulness, but can be avoided when the uncertainty is resolved. We also show in extensions that the borrower may increase his efforts over time as the relationship becomes more valuable to him, while the guarantor can resort to direct monitoring of the borrower's effort as a substitute for the suspension or termination of relationship.