Bank Debt
Typology
Sander Van Damme:
"Agarwal and Hauswald (2007) explain how banks have two sorts of debt they offer to borrowers, the first one, relationship debt, depends on private information the bank has through its relationship with the client; the second one, transactional debt, also called arm's length debt, is granted based on public information and does not require any relationship between the bank and the borrower. In this paragraph we will explore both types of debt and try to identify what type peer to peer microfinance offers.
Relationship debt, as is implied by its name, is debt offered to a borrower based on his or her relationship with the lender. It is dependent on private, usually soft information that only this potential lender has about the borrower. As in any relationship, this interaction is usually not limited to only one transaction, but it is of a more repetitive nature. Because of this preferred relationship, the funder can 'get to know' the borrower and learn some details that others do not know about, thus acquiring proprietary knowledge about the borrower. This leads to a greater ease for the borrowing party to receive the loan and get the necessary funding, but at a cost: the lender can extract a higher rent, knowing the true risks he takes and knowing what the borrower can afford to pay (Agarwal & Hauswald, 2007). The lender can enforce repayment through his relationship, which is built on trust and which supposes the borrower wants to keep his good reputation with the bank and other lenders (Ashta & Assadi, 2009a) On the other hand we have transactional debt; it is purely based on public, hard information available to all competing lenders. This leads to heavier competition amongst possible providers of money driving down interest rates. However, because of the lack of additional information for the creditors, it is harder to get the actual funding, (Agarwal & Hauswald, 2007). Since the lender cannot rely on his relation and the reputation of the borrower; he needs to rely on external mechanisms and putting in place controls to enforce repayment: receiving collateral, third party coercion and extraction, etc. (Ashta & Assadi, 2009a).
Given that a transactional lender is conscious of the extra knowledge a relationship lender possesses, the threat of adverse selection1 for him increases. This will lead the first to stay away from the bidding process. Of course, if he would not refrain from this competition he would be trapped in the winner's curse: if he does get to fund the loan, i.e. 'winning' from the insider, there would probably be a reason why this more informed lender did not want to fund the loan. Therefore he cannot win: if he as an outsider wins (gets to fund the loan), he loses because of the higher odds of default; if he loses, he simply does not get to fund a loan which the relationship banker found good enough to support (Von Thadden, 2004)." (https://www.zidisha.org/editables/news_docs/Louvain.pdf)
Discussion: How technology changes the relationship between relational and transactional debt
Sander Van Damme:
"In their 2003 paper, Hauswald and Marquez researched the impact information technology has on this model and banking competition in general. They hypothesized the improvements in information technologies might have two opposite effects. On the one hand, because of better processing techniques for all the information the relationship banker has, the information gap between insiders and outsiders should increase, leading to less competition and higher interest rates. However, as the internet and better communication technologies create more spill-overs, there would be faster dissemination of this 'inside' knowledge to the outside, taking away the informational asymmetry and driving down interest rates. This latter also leading to a second perverse effect where “easier access to information, by preventing banks from profiting from previously private information, results in less borrower screening.” (Hauswald & Marquez, 2003, p. 933). Even though they did not conclude which of these effects has the upper hand, both of these effects can have an important impact on the social lending market.
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We can understand how microfinance can generally be understood to offer relationship debt:
there is no public information on the borrowers since there are no records of previously repaid credit. It therefore all depends on the relationship of the banker with his clients, or perhaps of knowledge he gathers through contacts of the clients, as is often used in group banking. There is also little collateral being offered which could be used to enforce the loan, making it even more dependent on trust and goodwill. We notice how this reminds us of the Irish Loan Funds (see Chapter 2). Because of their close proximity and local presence, the funds were able to reliably lend out small amounts to poor Irish borrowers, while the bigger banks could not because of their absence in the area. Later on however, when public information on previous loans became available, banks could join the competition and try to outprice the loan funds.
Of course they should have been caught in the winner's curse: only funding the unreliable borrowers, while the funds were able to keep the best ones. Unfortunately, counterproductive legislation and the funds' mismanagement stopped them from exploiting this advantage and eventually led to their demise. This seems to us an important lesson for the current MFIs; while they are currently creating a credit history for the 'unbankable', they need to stay aware of upcoming competition for these 'newly bankable'.
When looking at social lending however, we notice the dual traits it possesses. At first it seems to be purely transactional lending: there is no relationship between the borrower and the lenders, no physical proximity and no promise for future repeat funding. However, it has some relational characteristics as well: it is not merely based on hard information, but involves people's stories, pictures and other means of wooing the lenders. For this reason, social lending sites are even being compared to dating sites (Hartley, 2010; Manjoo, 2006).
This soft information however, which used to define relationship lending and their insider advantage for the bank, is now being dissipated using improved information technologies to everyone bidding. There are no insider bidders anymore and competition drives the interest rates down, as was suggested by Hauswald and Marquez (2003). Therefore social lending continues to offer transactional debt, but includes private information in determining its lending terms. Nevertheless, although there is no relationship with specific lenders, a lock-in is created with the social lending platform. A registration fee needs to be paid when first starting with the platform and any positive feedback on current loans cannot be transferred to another website. However, this does not take away the previous conclusion that the loans between the peers themselves have a clear transactional aspect.
Given that microfinance offers relationship debt and social lending offers transactional debt, we need to ask ourselves what does peer to peer microfinance offer? Actually, it depends on each platform; for those that use a local MFI as an intermediary, the website is closer to microfinance and engages in relationship debt. On the other hand, platforms such as Zidisha allow direct interaction between lenders and borrowers, and although they do incorporate the soft information aspect in their bidding process; they are actually closer to arm's length lending by offering open market competition and no insider information amongst the lenders." (https://www.zidisha.org/editables/news_docs/Louvain.pdf)