Monitoring cost transaction interlinkage and the selection of optimal loan contracts: evidence from rural India

Abstract

Costly monitoring is an important market imperfection in developed as well as developing economies. In developed countries monitoring costs are usually minimized through intermediation. The intermediation process is hampered, however, by market fragmentation typical of developing agrarian economies. Borrowers may choose to use private moneylenders rather than formal banking sector intermediaries. A theory of loan contract choice is developed which emphasizes the role of monitoring costs and transaction interlinkages. The theory is tested against survey data from rural West Bengal. The results are consistent with the main conclusions of the model.