Peer influence, strategic discretion and loan defaults in community lending: Evidence from Indian Demonetization



Prior research on community lending models in microfinance has largely emphasized the benefits of borrower-to-borrower relationships that enable peer monitoring, thus facilitating reliable lending transactions with low servicing costs. We examine whether and how these borrower-to-borrower relationships might also facilitate the spread of loan defaults during a crisis. We investigate this issue through a quasi-experimental design that leverages India’s 2016 demonetization policy, a shock that revoked the legal tender status of 87 percent of the country’s currency in circulation, triggering a massive and unforeseen constraint on borrower liquidity. Using proprietary data on approximately two million borrowers from a leading Indian microlender, we find strong evidence that defaults spread through peer influence: the number of a borrower’s peers who defaulted immediately following demonetization is positively associated with that borrower’s own likelihood of default in subsequent months. We further find that the strength of this peer influence differed based on a borrower’s level of strategic discretion in making timely loan repayment: borrowers with a greater ability to repay were more influenced by the defaults of their peers (incoming peer influence), and their defaults were also more influential upon their peers (outgoing peer influence). Our study thus uses the unique context of community lending following demonetization to contribute new evidence of peer influence during a crisis, while identifying the particular role of strategic discretion as a key condition underlying such influence.

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