Money Lending and Why People Borrow From the Mafia

By now most people are familiar with the outrageous interest rates money lenders charge the poor. In rural Pakistan the average interest rate was 78% even though the default rate was only 2%. In Chennai, India a working capital loan had an interest payment of 4.69% per day. To put that in perspective, a $5 loan at 4.69% interest per day would leave a debt of $93 million if it goes unrepaid for a year.

This is an all too familiar story around the world. What is also a familiar story is that money lenders often put extreme pressure on the poorest of the poor to pay back their loans. One ad in a Sunday newspaper in India once told the story of money lenders threatening to send eunuch’s to people who have defaulted because people have the belief that seeing a eunuch’s genitals brings bad luck. In the US would borrow from the mafia or other groups who are not bound by any laws to recover the debt. These stern loan sharks and the mob have shown to have low default rates so this begs the question, why doesn’t an honest upstanding person lend this money instead? Wouldn’t any one rather borrow from someone who won’t break their kneecaps if they don’t repay?

The notorious Italian Mafia

The notorious Italian Mafia

The obvious answer is yes but we have to ask ourselves another question. Who would you be more worried about paying back, someone who leaves an angry message on the phone or someone who shows up at your front door threatening physical violence? As you can imagine, those who will use any means necessary will recover more money than those who are bound by moral principles or other means to recover money. The mob and aggressive loan sharks have a cost advantage over the honest because they will have lower default rates.

But their cost advantage goes further. If you know that who you are borrowing money from will use any means necessary to collect, you are going to do your absolute best to pay back the money. Similarly, the mob knows the threat of violence knows they will get the best effort out of people who borrow. Therefore not only do they have a cost advantage in terms of collecting money but they also have a cost advantage in screening borrowers.

The honest money lender doesn’t stand a chance. He takes more diligence assessing the risk of the borrower which costs time and time costs money. He also is limited in he means to collect payment.  His honesty forces him to charge high interest rates to make up for these costs and more often than not it prices himself out of the market. Therefore it is no wonder why the poor resort to such means when they are in need of a loan. It is the only realistic option. A terrible option, yes, but one that will exist for the poor in any society.

It is doubtful that any society will fully be able to rid itself of loan sharks of the nature we hear about because of the strong cost advantage they have. Such activity in the US has no doubt gone down but it would be naïve to think we have fully put it in the past. We all wish the poor could get the best rates possible but for many it unfortunately can come at a high cost. A cost that can be justified on the economics but obviously a cost that we wish the poor didn’t have to face.

All the more reason for someone like myself with the ability to create jobs and increase incomes for the poor to do exactly that. It would be foolish to think that we can eradicate the supply of money lenders or the mob but what we can do is work to eradicate the demand for it.

NOTE: I have been going back through Poor Economics which is one of the few books I would highly recommend for those who are serious about the poor. It will challenge the way you view and think about the poor which is exactly what is needed given so many of our efforts have not amounted to much. It has a chapter on the economics and reality of micro lending.

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