Does Informal Finance Help Formal Finance? Evidence from Third Party Loan Guarantees in China

Abstract

Building on the important study by Allen, Qian and Qian (2005) and Ayyagari, Demirgüc-Kunt and Maksimovic (2010), we examine whether third party guarantors play an effective role in assessing loan risk. Using a proprietary database of third party loan guarantees in China, we find strong evidence that guarantors and banks disagree on pricing loan risk, and that banks can better predict loan defaults than guarantors. We also find that the probability of loan default is affected by the capability of guarantor officers. Our findings question the contribution of soft information in the improvement of credit scoring and support the view that informal finance should be limited. This paper also supports the implications of studies on human capital in financial intermediation.