Social Capital as a Risk Mitigation Mechanism in Informal Credit Markets: A Theoretical Model

Purpose: This paper formalises social collateral as an endogenous decision variable to explain interest rate heterogeneity and persistent poverty traps in informal credit markets. Study design: Household optimisation is embedded within a lender zero-profit condition. A default probability function captures strategic complementarity — dependence on both own and community social capital. Dynamic social capital evolution is characterised via an optimal control framework solved using Pontryagin’s maximum principle. Findings: The equilibrium interest rate decomposes into a risk-free component and a social collateral premium decreasing in community social capital. Strategic complementarity generates three equilibria: a low-capital trap, a Pareto-superior high-cohesion equilibrium, and an unstable tipping point. The system exhibits path dependence, hysteresis, and decentralised under-investment due to network externalities. Contributions: The paper endogenises social capital in informal rate setting, explains bimodal informal rates through multiple equilibria, analyses continuous-time convergence and hysteresis, and derives an explicit welfare-optimal subsidy rule, implicit in the model’s endogenous objects—extended to a dynamic path. Implications: For researchers, the model yields testable predictions on non-linearity, bimodality, and threshold effects. For practitioners, interventions must exceed the tipping point to trigger self-reinforcing dynamics. For policy makers, the optimal subsidy guides programme design and hysteresis justifies time-limited but intensive community development initiatives.