Financing from Family and Friends

Abstract

The majority of informal finance, in developed and developing countries, is provided by family and friends. Yet existing models of informal finance better fit “informal moneylenders” insomuch as they fail to match two salient characteristics of family finance: family investors often accept below-market or even negative returns, and despite this, borrowers tend to prefer formal finance. We explain both of these characteristics in a model of external financing that allows for social preferences between relatives or friends. The social preferences make family finance cheap but also create shadow costs that nonetheless discourage its use: Committing family funds to a risky investment crowds out familial transfers in low-consumption states, and undermines limited liability. The very characteristics that generate intra-family insurance thus render family finance a poor source of risk capital. In contexts where contracts must harness social ties to overcome capital constraints, our findings suggest that third-party intermediation and semi-formalization may be crucial for promoting risky investment. This is relevant to the limited success of group-based microfinance in generating entrepreneurial growth, and to the emergence of social lending intermediaries and crowd funding.