Rational Herding in Microloan Markets

Rational Herding in Microloan Markets

Microloans have been used in various countries – from poor developing countries to poor areas in developed countries – to lift people out of poverty.  Microloans are small loans made by either for-profit or non-profit firms with low interest rates.  The loans are as small as $100 or $200 dollars, and can be used to purchase capital goods or help tide people over during shortages of income.

This paper, published in Management Science studies the microloan market in the US.  It looks at lenders on Prosper.com and the kind of herd behavior in the market.  Rational herding is a type of information cascade, where lenders follow others based on rational choices.  The authors, Juanjuan Zhang and Peng Lei, found that there was rational herding behavior among lenders.  This means that seeing that other lenders are lending to certain borrowers leads to more lending to those borrowers.  The lending done by some lenders implies creditworthiness of those borrowers, regardless of the actual creditworthiness.  The cascade flows, and lenders attract lenders.

So the big question is whether or not the rational herding observed is actually correlated with better loan performance (and therefore loans being creditworthy).  The authors found that an increase in funding lead to a decrease in loan default.  That means that the rational herding had a positive outcome.  The authors then compared this to irrational herding and found that rational herding better explained loan default than irrational herding.  They conclude that if they were to use an irrational herding model, they would incorrectly conclude that lenders are worse at making investments than they really are.