European Journal of Law and Economics, 12: 193–215, 2001

© 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.

In Offense of Usury Laws: Microfoundations of

Illegal Credit Contracts
DONATO MASCIANDARO donato.masciandaro@uni-bocconi.it
‘Paoli Baffi’ Center for Monetary and Financial Economics, Università Commerciale Luigi Bocconi,
Via U. Gobbi 5, 20136 Milan, Italy

Abstract
Several European countries base their anti-usury laws on the definition of interest ceilings. Underlying this
approach is the identification of high interest rates with the usurious nature of the relative credit contract; hence
usury is nothing more than a particularly onerous credit contract. The present paper contradicts this traditional
view by presenting a general micro-founded model of credit contracts that arrives at a few conclusions, before
in a static and then in a dynamic contest. Firstly, it demonstrates the specificity of the usury contract with
respect to the bank contract, pointing up the particular nature of those who supply and demand usurious
credit. Secondly, it demonstrates that in environmental situations with little protection of property rights and
a propensity to illegality, the decision of a borrower to turn to a usurer may be efficient from the Pareto
standpoint and thus not the result of a rationing equilibrium in the bank credit market, as is commonly thought.
Thirdly, it deduces from this the insubstantial link between “interest rate level and the usurious nature of the
contract.” Hence two consequences for policy: (a) it is more effective to combat usury by improving the laws
and law enforcement to better protect property rights, rather than introduce rate ceilings; and (b) in any case,
the usury market can be reduced but not eliminated, since it is a meeting place for particular borrowers and
lenders of funds.

Keywords: usury, law, credit markets

JEL Classification: K42, G14, G28

Several European countries base their anti-usury laws on the definition of interest ceil-
ings. Underlying this approach is the identification of high interest rates with the usurious
nature of the relative credit contract; hence usury is nothing more than a particularly
onerous credit contract.
The present paper contradicts this traditional view by presenting a micro-founded
model of credit contracts that arrives at a few conclusions. Firstly, it demonstrates the
specificity of the usury contract with respect to the bank contract, pointing up the partic-
ular nature of those who supply and demand usurious credit. Secondly, it demonstrates
that in environmental situations with little protection of property rights and a propensity
to illegality, the decision of a borrower to turn to a usurer may be efficient from the
Pareto standpoint and thus not the result of a rationing equilibrium in the bank credit
market, as is commonly thought. Thirdly, it deduces from this the insubstantial link
between “interest rate level and the usurious nature of the contract.” Hence two conse-
quences for policy: (a) it is more effective to combat usury by improving the laws and
law enforcement to better protect property rights, rather than introduce rate ceilings; and
194 MASCIANDARO

(b) in any case, the usury market can be reduced but not eliminated, since it is a meeting
place for particular borrowers and lenders of funds.
Therefore, is the usurer only an illegal banker? In general, the economic literature
offers an affirmative response to this question: the usury market is attributed no logical
or theoretical specificity that differentiates it from the credit market.1 The usurer is an
individual who offers a lending contract with the same qualitative characteristics as
the bank contract but at quantitatively exorbitant conditions. One who accepts those
conditions does so because he has been rationed by the banking system, as a result of
the imperfect competition or imperfect information in that system. This approach leads
to two principal conclusions: the difference between a usury contract and a bank contract
is the different interest rate level; the existence of usury depends on imperfections within
the credit market.
This paper takes a different approach: usury contracts are qualitatively different from
bank contracts because of imperfections external to the credit markets, associated with
inefficiencies in the mechanisms for protecting and transferring property rights. In a con-
text where the protection and transfer of property rights are imperfect, in fact, the value
of goods and properties fungible as collateral for loans depends on the “technology”
available to the creditor to enforce them. The specificity of usurious credit derives pre-
cisely from a different “technology” (illegal) for the recovery of credits and thus from a
different valuation of the collateral offered and the expected future income of the debtor.
The model presents a series of characteristics: it is more general than the traditional
approach, since the cases of imperfection within the credit markets can be introduced
as special cases; the difference between a usury contract and a bank contract does not
necessarily lie in a different interest rate level; usury also exists where there is competi-
tion and perfect information within the credit markets; the characteristics of contracts are
endogenous with respect to the characteristics of the lenders, while, as mentioned earlier,
often in the traditional literature the distinctive characteristics of usury contracts with
respect to bank contracts (e.g., higher rates in the illegal contracts than those permitted
by bank contracts) are exogenously fixed to study the consequences on the behavior of
operators.2
This paper is structured as follows. Section 1 briefly examines anti-usury legislation in
the principal European countries, focusing in particular on the existence or nonexistence
of interest rate ceilings. Section 2 develops the model in the case where there is no
renegotiation and the agents act simultaneously. Section 2 also examines the problem in
a dynamic context. Section 3 speaks of Shakespeare’s Shylock. Section 4 offers a critical
look, based on the theoretical results, at the approach to anti-usury regulation based on
interest rate ceilings.

1. Usury laws in Europe

The usury legislation existing in the European countries is characterized primarily by

the decision whether to legislatively or administratively establish maximum legitimate
interest rates.
France, Italy, Portugal and Switzerland belong to the group of states that have estab-
lished an objective control criterion. In these countries, control is usually both preventive,
IN OFFENSE OF USURY LAWS 195

through an administrative system of checks and sanctions on lending parties, regardless

of whether the borrower raises a controversy, and subsequent, when the judicial authority
determines the legitimacy of contractual conditions submitted to it. In other countries
such as Germany, Austria, the United Kingdom, Spain, Denmark, Ireland, Sweden and
Finland, where usury rates are not determined a priori, the courts concretely evaluate
the legality of interest agreements in accordance with legal guidelines that vary radically
from country to country.

1.1. Austria

In Austria the criminal laws on usury, with no maximum threshold for determining
capital benefit by objective parameters, which must be “clearly disproportionate to the
value of the service” to be deemed usurious, contemplates better specification for certain
aspects.

1.2. Belgium

The consumer credit law of 21 June 1991 attributes to the King the power of establish, at
least every six months, the maximum effective global annual rates, after consulting with
the Consumers’ Council and the National Bank. The maximum rates take into account
the type, amount and duration of the credits. Violation of the interest ceiling in granting
loans exposes the lending companies to penal and administrative sanctions, including
suspension or revocation of their authorization to conduct lending activity.
From the civil standpoint, the law contemplates the reduction of the borrower’s obliga-
tions to repay the principal. Furthermore, Article 1907 ter of the Civil Code establishes
that, if by abusing conditions of need, weakness, sensitivity or ignorance of the borrower,
the lender solicits for himself or for others interest or other benefits manifestly exceed-
ing the normal interest and coverage of lending risk, the judge, if so petitioned by the
borrower, reduces said obligations to repayment of the principal and payment of interest
at the legal rate.

1.3. France

France was the first European country to pass an anti-usury law for market control
purposes, introducing a statute stripped of any element other than the usurious nature of
loans, predetermined administratively.
The usury problem was first regulated by Law no. 66-1010 of 28 December 1966,
which defined as usurious any loan on which the effective global interest rate was greater
than the lower of (a) the effective average rate practiced during the preceding six months
increased by 25% and (b) twice the average rate on debentures issued during the previous
six months by private companies. This legal system presented a number of practical
difficulties, which were later remedied in Article 29 of Law no. 89-1010 of 31 December
1989 (better known as the Neiertz Law, from the name of State Secretary Véronique
196 MASCIANDARO

Neierts). This law identifies the legal limit as exceeding by one-third the average of
the rates practiced in the previous quarter by banks on transactions of the same nature
involving similar risks, defined by the Minister of Finance on the opinion of the National
Credit Council. The law identifies at least then different usury rates for corresponding
loan categories.

1.4. Germany

In Germany usury is considered a crime by Article 302a StGB (Strafgesetzbuch) and is

normally punishable by three years of imprisonment or a fine.
From the civil standpoint, Article 138 BGB (Civil Code) contains general provisions
regarding legal transactions contrary to public morality, which permit magistrates to
intervene in case of contracts in which one party has exploited the need or inexperience
of the other in order to derive benefits disproportionate to the object of the contract.
No parameter, however, is provided for assessing the usurious nature of the benefits,
which are described as “significantly disproportionate.”
Thus, as occurred in Italy with the pre-existing legislation, German case law in inter-
pretation necessarily refers to objective parameters, in this way approaching the practice
in countries where the predetermined rate model was adopted, with the additional onus,
however, of proving elements of a subjective, undetermined nature.
The parameter for disproportion refers to the actual annual rate, including lending
expenses and charges, or to interest greater than 30%, or exceeding 100% of the base
rate resulting from the monthly reports of the Deutsches Bundesbank, while for usury in
financial leasing, a rate is deemed demonstrably disproportionate if it is greater than or
equal to 50% of the installments.

1.5. United Kingdom

In the UK there are no civil or criminal statutes that place limitations on interest
covenants. The legislation on usury, in fact, was abrogated by the Usury Laws Repeal Act
of 1854 and by the Moneylenders Act of 1974. However, based on the Consumer Credit
Act of 1974, the courts can apply correctives in cases of “extortionate credit bargains.”
By “extortionate” Section 138 of the Law in question intends not only contracts at exces-
sively exorbitant rates but also those conforming to the rules of commercial propriety
and those whose stipulation explicitly evidences the borrower’s condition of financial
difficulty.

1.6. Ireland

Until 1995 the usury problem was regulated by the Moneylenders Act of the 1933, which
contemplated a rate of 39%. With the approval of the Consumer Credit Act of 1995, the
Irish Parliament laid down, in Articles 47 and 48, a different reference regulatory context
in which it is the court that determines whether the rates applied are excessive.
IN OFFENSE OF USURY LAWS 197

The rate is assessed by comparing it to the rates practiced in the market, considering
the age and business experience of the borrower, as well as the degree of risk and the
guarantees required by the lender and his costs. If, in relation to the above, the court
deems the lending conditions usurious, it can make the contract fair by reducing the
rates and by altering the contract clauses. Protection under the Consumer Act cannot be
invoked for secured loans or against banks.

1.7. Italy

Law no. 108 of 7 March 1996 introduced a system for objectively determining usuri-
ous rates, whereby rates equal to the average rate of the quarterly interest on similar
categories, as determined by the Ministry of the Treasury and published in the Official
Journal pursuant to Article 2 of the same law, increased by half are always considered
usurious.
The determination of the threshold rate presupposes constant monitoring of the credit
market, conducted on a quarterly basis and aimed at identifying the actual global average
rate (tasso effettivo globale medio or TEGM) of the interest practiced by legal operators
as a function of various types of homogeneous transactions.
The threshold rate consists of a value equal to one-and-a-half times the TEGM for the
previous quarter for the same class of transactions, adjusted to reflect any changes in the
official discount rate subsequent to that quarter.

1.8. Luxembourg

In this important financial market, usury is governed by Article 1907-I of the Civil Code,
which describes conduct as usurious when the lender, consciously abusing the difficulty,
heedlessness or inexperience of the borrower, makes the borrower promise for him or for
others an interest rate or other benefits that manifestly exceed the normal interest, taking
the coverage of lending risk into account. In these cases the court, at the request of the
borrower, reduces his obligations to repayment of the principal loaned and the payment
of interest. The reduction applies to the payments effected by the borrower provided that
the request is made within one year from the day of the payment.

1.9. Netherlands

This country lacks a legal definition of usury, and case law generally intervenes against
usurious agreements based on the general principles of contractual good faith. In the
area of consumer credit, however, there is an administrative regulation that provides
for the determination of maximum rates based on the duration and amount of the
credit. Violations of said limits are punishable by administrative sanctions against the
lender.
198 MASCIANDARO

1.10. Portugal

With Legislative Decree no. 262/83 of 16 June 1983, Portugal amended Article 1146
of its Civil Code by introducing the principle that any credit contract stipulating annual
interest that exceeds the legal interest rate increased by 3%–5%, depending on the exis-
tence of real collateral, is considered a usurious loan. Clauses providing for late-payment
interest at rates 7% or 9% higher than the legal rate are also considered usurious. The
legal rate is determined differently for private and bank loans (at March 1996 the legal
rate was set at 15% for private individuals – Decree no. 339/87 of 24 April 1987 –
and at 18% for banks and financial companies – Legislative Decree no. 83/86 of 6 May
1986). The civil sanction for usury is reduction to the maximum legal rate of the interest
convention, and the court can officially apply said reduction even if the borrower waives
it. Administrative sanctions are contemplated for financial organizations found guilty of
usury. The National Bank can also order the suspension or revocation of the authorization
to conduct lending activity.

1.11. Spain

In Spain, with the revision of the penal code under Ley Orgànica no.10 of 1995, usury
is no longer considered a crime.
In the absence of any specific legislation, however, the Spanish courts can go so
far as to declare null and void any loan contract at manifestly excessive rates based
on an assessment of the borrower’s need and experience at the time the contract was
stipulated.

1.12. Switzerland

Swiss federal civil law establishes no maximum allowed interest rate. Article 73 of the
Code of Obligations, in paragraph 1, sanctions the freedom of the contracting parties
to agree on an interest rate, establishing subsidiarily a rate of 5% when it is not fixed
contractually by law or by practice. Article 795 §1 of the Swiss Civil Code guarantees
the same contractual freedom regarding loans secured by liens on assets. The anti-usury
provisions represent the only limitation on this freedom. Article 795 §2 of the Swiss
Civil Code allows the cantons to establish by law the maximum interest rate for credits
secured by liens on assets. The parliament then deferred to federal and cantonal law the
repression of violations concerning conventional interest.
A few cantons have signed the intercantonal agreement on the repression of abuses of
conventional interest of 8 October 1957, effective date 10 July 1958. Article 1 fixed a
rate of 1.5% per month on the sum actually owed. This amounts to a maximum rate of
18% per annum. Some cantons have passed laws in this area. The Canton of Zurich (not
a signatory of the aforesaid Agreement), for example, has established a maximum rate
for conventional interest of 18% of the amount owed.
The Swiss Federal Court, called to judge these cantonal provisions, sanctioned their
legality. Currently, considering also the case law of the High Court, it is commonly
accepted that usury exists when the annual interest rate exceeds 18%.
IN OFFENSE OF USURY LAWS 199

2. The micro-foundations of usury contracts

In the previous section we established that anti-usury regulation still makes use of interest
rate ceilings. Thus any loan contract on which the interest rate is excessively onerous is
usurious, and therefore illegal. From this standpoint, there is no specificity in the nature
of illegal contracts with respect to legal contracts, on either the supply or demand sides.
Economic theory also generally reflects this approach: on the supply side, an excessively
onerous loan contract can be offered by any party, physical or juridical, authorized or
not. At the same time, on the demand side, anyone accepting an excessively onerous
loan contract is probably rationed, or excluded, by other lending sources.
The approach we propose in this paper will lead us to discover, however, a specificity
of the usury contract from both the supply and demand standpoints.3
Starting from a standard indebtedness model,4 let us consider an economic agent who
intends to finance a certain expenditure project O, in the presence of a credit market in
which both banks that usurers are operating.5 This project requires a given initial loan
I; against this initial loan, the borrower guarantees repayment because of future income
X, which is not 100% certain, however, so repayment risk exists.
The uncertainty about the future income of the “aspiring” debtor can be reflected
simply by assuming that said cash flow can have a maximum value of P (with an
occurrence probability of p), or a minimum value of 0. This information is known to
both the borrower and the lender. The uncertainty over the level of income securing the
repayment represents the riskiness of the expenditure project.
A situation of information asymmetry thus exists between the economic agent and the
supplier of funds—be it a bank or usurer—related to the actual income flow with which
the credit will be repaid. While the borrower of funds can determine, without effort or
cost, the level of income at the moment it becomes available, the lender can only come
into possession of information on the extent of this income at the moment when the loan
must be repaid. Let us imagine, in other words, that neither the bank—through legal
channels—nor the usurer—even utilizing extra-legal means—are capable of knowing
costs without spending money and/or time the extent of the possible repayment, at the
moment the income becomes effective.
Let us then assume that:

(1) pXs > I

This means that the income expected from the loan exceeds its initial cost, so the
expected benefit of the creditor can be assured firstly by a clause for expropriation of
the borrower’s income, in case of nonpayment of the loan and in the absence of other
forms of collateral. We shall describe these projects as creditworthy.
Let us further assume that the economic agent is the owner of a good C, not liquidable
for purposes of the immediate financing of the project but accepted—by both the bank
and the usurer—as collateral for the loan.
These causes imply that in case of insolvency the debtor must transfer to the creditor
his income and his ownership rights on the good offered as collateral. When the contract
200 MASCIANDARO

does not contemplate collateral, insolvency obliges the debtor to cede only his income.
This produces constraints on the extent of repayment R:

• since the agreement is a credit contract, R cannot obviously be less than I, so that the
interest rate r on the loan will not be negative;
• R must be less than P , so that the debtor has an incentive to seek financing for his
expenditure project;
• so that it not be to the benefit of th edebtor to declare in every case that he cannot repay
the debt—whatever his actual income X—R must be less than C. A more interesting
case is where the legal economic value of the collateral—plus the minimum guaranteed
income—is not sufficient to cover the initial outlay of the lender, since under more
restrictive assumptions, we would be able to determine the differences between bank
contracts and usurious contracts. We therefore take this relationship to be valid:

(2) R≥I >C

Thus the loan contract G = GR C obliges the debtor to repay the debt. In case of
failure to pay, the creditor becomes owner of the collateral.
An economic agent wishing to finance an expenditure project may apply without dis-
tinction to banks or to usurers. Of course, all other conditions being equal, applying
to usurious lenders implies an illegality cost. Coming into contact with a usurer means
agreeing to pay a “risk premium” that the lender requires either in exchange for sup-
posed advantages compared to the bank (ready availability of the funds, scant screening
formalities, discretion) or the coverage of greater client risk, which would manifest itself
in the sole fact of seeking illegal credit.
The risk premium, which we assume to be a constant value E,6 would thus represent a
sort of duty to compensate the mechanism of adverse selection that by definition would
characterize the clients of usurers.
For the potential debtor, the illegality cost varies according to his subjective, economic
and, if we wish, psychological state. The monetary value of the surcharge due to the
usurer may be low or high for an operator, depending on his economic and subjective
state. Entering into a contract with a usurer may involve risks and costs, sometimes
difficult to quantity. But for some it may offer advantages, if for some reason—fiscal,
for example—they prefer an irregular, informal loan or if they are forced to seek one by
grave and exceptional circumstances.
If we identify the sensitivity of a given businessman to entering into an illegal credit
contract by the non-negative parameter s, we can differentiate between two cases: s > 1
will signify aversion to illegality, s < 1 a propensity to illegality.
What, in essence, differentiates the two providers of credit?
Banks tend to assign a lower economic value to collateral than the borrower. This is
because, for example, transfers of ownership on the collateral are not without costs. So
the valuation of the collateral by banks differs from that of the borrower: the costs of
liquidating the good are reflected in a valuation of the collateral equal to b C, where 0 <
b < 1. The parameter b can also be interpreted as a reflection of the level of effectiveness
of the system protecting property rights, in terms of their (re)assignment.
As far as usurers are concerned, there are two differences with respect to legal entities.
IN OFFENSE OF USURY LAWS 201

(i) The first difference is that the value of the collateral for a usurer is equal to uC,
with u > 1. This may be justified by situations in which the collateral has a peculiar,
illegal value for the usurer, in addition to the general traditional value typical of an
economic agent, so that the final value for the usurer is greater than that perceived
by the economic agent (e.g., company or properties to expropriate for purposes of
money laundering, the borrower’s state of dependency, sexual guarantee), and even
more so for a bank. In other words, the collateral has a special use value for the
usurer, since it is illegal. Let us define the additional value the usurer attributes to
the collateral as illegal benefit.
(ii) The second difference concerns the ability to make the debtor pay the surcharge E
(illegality cost) as a consideration for the special service the usurer offers with respect
to a bank, which may consist of simple willingness to loan to parties defined as
marginal or the features of the lending process (rapidity, flexibility, confidentiality).

This difference between legal and illegal credit intermediaries identified by the assump-
tion of illegal benefit explains more clearly the interest of condition (ii) described above,
i.e. that the legal economic value of the collateral plus the income flow of the debtor does
not exceed the amount of the credit, including interest. Since the difference between legal
and illegal lenders lies precisely in their valuation of the collateral, excessive collateral
would not help us grasp this difference.
As far as the structure of the credit markets, legal and illegal, is concerned, let us
analyze the case of perfect competition.
Let us consider a situation in which the loan contracts—legal and usurious—cannot
be renegotiated, in either the legal or illegal market. The absence of renegotiation in
the legal market can be justified on the basis of the existence of juridical and institu-
tional constraints, established and above all credible. In the illegal market, extra-legal
instruments of coercion can ensure observance of the rule of non-renegotiability.

2.1. The role of collateral

We shall describe a situation in which all markets for financing are competitive; they
are characterized by lenders in perfect competition in offering loan contracts in their
respective markets, legal or illegal. The competition between lenders, legal and illegal,
has two consequences:

(i) each of them has the option of participating in the perfectly competitive market or
withdrawing from it;
(ii) the contracts signed are the result of the optimal choice of the debtor, under the
constraint of participation of the lenders, of zero surplus profits.7

Starting with bank contracts, it is easy to demonstrate8 that the optimal contract
requires no collateral, i.e. corresponds to G∗ R∗ 0. In fact, the competition among
banks, by nullifying profits P , implies that:

(3) I = pR∗
202 MASCIANDARO

Equations (1) and (3) show that the repayment of bank debt R∗ , for creditworthy projects,
is lower than the maximum value of the debtor’s income R∗ < P , so the agent signs it,
and his expected profit is equal to:
(4) pP − R∗  = pP − I > 0
For non-creditworthy projects, the repayment of the debt would be greater than the
maximum value of the debtor’s income, so it would behoove him not to sign the loan
contract. Non-creditworthy projects are not financed in the legal market.
Contracts without collateral are the best possible in the legal markets. In fact, let us
consider any other bank contract with collateral GbR C. With the same condition
R < P , perfect competition among banks implies:
(5) I = pR + 1 − pbG
Thus the debtor’s expected profit is equal to:
(6) pP − R − 1 − pC = pP − 1 − p1 − bG − I < pP − R∗ 
The borrower will therefore prefer G∗ R∗ 0 to any GbR C.
The irrelevance of the collateral in the legal market can be easily explained: if the
presence of collateral in no way indicates the quality of the project to be financed, and the
market is “dominated” by the borrower, since the competition among lenders is perfect,
even though the collateral has a positive, though depreciated, economic value for the
banks, it disappears from the optimal design of the bank contract. For the debtor, in fact,
the advantage of not losing his collateral in case he fails to repay the debt is greater than
the interest rate savings he could obtain on a bank loan covered by collateral.
In competitive legal markets there is therefore no exclusion for worthy projects: each
expenditure project X p, with its respective borrower, characterized by his own specific
profitability and risk profile, finds an optimal contract. Unworthy projects, on the other
hand, are not financed.
The characteristics of the optimal legal contract GR∗ 0 vary according to the char-
acteristics of the project to be financed and the amount of the loan. The definition of the
interest rate produces the equilibrium level r ∗ :
R∗ − I 1 − p
(6a) r ∗ = =
I p
What happens if we consider that the usurers in the market are also in perfect com-
petition? The fact that they place great importance on collateral, for illicit purposes,
drives them to offer a contract GuR∧ C which, since the illegal markets are also in
perfect competition, also derives from the constraint of participation of the lenders, i.e.
the return, net of the risk premium is equal to the costs:
(7)
+ 1 − puG − E
I = pR
In this case, is the debtor’s expected profit, which must also reflect the subjective cost
of the illegality, greater or less than could be obtained with the optimal bank contract?
Recalling that u > 1:
(8)
− 1 − pC − sE = pP + 1 − pu − 1C − I − s + 1E
pP − R
IN OFFENSE OF USURY LAWS 203

we may conclude:
Proposition 1 If it is true that:

(9) 1 − pu − 1C > Es + 1

then the debtor prefers the usurer to the bank.

Proof: Compare (6) with (8).
Expression (9) implies that the usurious contract is more efficient than the legal con-
tract, if the illegal benefit valued by the usurer is greater than the illegality cost, as
globally perceived by the borrower. For the debtor the net advantage obtainable with usu-
rious credit, if the debt is repaid, may exceed the advantage of not losing the collateral
in case of failure to pay the bank loan.
The proof that the usurious credit is optimal is even stronger:
(i) the greater the value of the collateral C, the illegal additional value u attributed to it
by the usurer, and the underlying risk of the project, which increases as p declines;
(ii) the lower the price of the illegality E, and the lower the sensitivity s of the debtor
to being in contact with illegality.
If the condition identified is verified, the greater efficiency of the usurious contract is
explained by the fact that the borrower is presented with conditions subjectively more
attractive, although he is aware that the conditions of the usurious contract are better
because of the possible illegal value of the collateral, provided that this benefit exceeds
the illegality cost.

2.2. The role of renegotiation

An important result was achieved in the previous section: it demonstrated that the phe-
nomenon of usury is not necessarily due to the “shortsightedness” of the debtor but may
be the result of a rational choice. This occurs because the usurer has a higher valuation
of the collateral than the bank and is therefore willing not only to finance projects with
a higher probability of failure but also “compete” with the bank by financing the debtor
at lower interest rates. In exchange he obtains a higher expected value in case of failure
because he appropriates the collateral. It is precisely this last aspect, however, that merits
special attention. It is true, in fact, that:
Proposition 2 In the static model of the previous section, the usurious interest rate is
higher than that of the bank only if the borrower is propensive to illegality, i.e. s < 1.


Demonstration: The level of the actual rate on the usurious contract is rˆ = R+E−I
I
.
Replacing the equilibrium value of the repayment of the usurious loan in this equation
taken from (7) and comparing it to (6a), we find that the usurious interest rate is higher
than the bank’s, under the condition that:

(9b) 1 + pE > 1 + puG

204 MASCIANDARO

But in the static model usury exists only if 9 is satisfied, or if it occurs that 1 −
pu − 1G > es + 1, which can be rewritten as uG1 − p > E1 + s + G1 − p.
Replacing this last equation in 9b we find that 1 + pE > E1 + s + G1 − p, i.e
sE < pE − G1 − p, rewriting it and remembering that p is always less than 1 because
it is the probability of obtaining the maximum value, we demonstrate that:
1 − pG
s < p− <1
E
Proposition 1 has an immediate economic interpretation. Since there is no rationing
on credit, the usurer, to be competitive, must accept a lower interest rate than the bank’s
because he must compensate for cost E sustained by the debtor to contract in the illegal
market. The usurer may find this acceptable, since the interest rate is compensated for
by the appropriation of the collateral in case of bankruptcy. Of course, the less adverse
the debtor is to illegality, the less he must compensate for cost E. If the debtor is a lover
of illegality, the usurer could even demand a premium from him.
This result, however, poses a few problems. Proposition 2 tells us that only when the
debtor is inclined to illegality can the usurer demand a higher interest rate than the banks.
We might assume that this is not the most common case. In fact, where G is sufficiently
higher than E, the above inequality has never occurred (s, in fact, is greater than zero).
Thus Proposition 2, in realty, teaches us that under highly restrictive conditions the usurer
asks for a higher interest rate than a bank.
To understand the paradox of the presence of the usurer, we shall seek to develop a
model. Let us proceed by steps:
Case A: Let us imagine an entrepreneur without capital but with an investment project
(in t = 0) that in successive and final periods (let us say t = 2) produces assured profits
sufficient to cover the cost of capital. It would obviously be efficient if an investor (bank)
financed this project. If, on the other hand, the entrepreneur’s profit cannot be verified,
and a problem of asset diversion therefore exists, this does not occur because of the
bank’s fear that the entrepreneur “will conceal the loot.”
Case B. The scenario changes if we assume an intermediate period (t = 1). In t = 1, a
pay-off occurs that is positive but not always verifiable. The bank would agree to finance
the entrepreneur for the short term (until t = 1). If there is no repayment in t = 1, it can
“threaten” to force the entrepreneur into bankruptcy, so the assured profit in t = 2 will
not be realized. The threat is credible, because the creditor knows that in any case he
would not be repaid in t = 2. It is therefore beneficial to recover the collateral in t = 1
rather than in t = 2.9
In the model we are considering there is an addition with respect to B in t = 1
nature steps in and there may be two observable scenarios (good scenario in which the
pay-off is positive, bad scenario in which the pay-off is zero).10 Thus the pay-off is not
only verifiable but also uncertain. If the pay-off in the intermediate period is sufficiently
large, the Bank will continue to lend money to the entrepreneur in t = 0 until t = 1.11
The problems arise in t = 1. If nature is benign, we are in case B: the entrepreneur
pays the bank and proceeds in t = 2 to “enjoy” the assured profits. But if “things go
awry” in t = 1, we are in case A: the bank cannot be repaid. Nature is at fault, and in
the subsequent period there is assured, positive profit. It would therefore be efficient to
renegotiate the loan. The problem of asset diversion in t = 2 would not exist (case A), so
IN OFFENSE OF USURY LAWS 205

the bank would not be willing to renew the loan (it would prefer to collect the collateral
immediately in t = 1 rather than wait for t = 2 if the discount rate is positive). This also
applies if we assume that the problem of asset diversion is not total and the bank can
recover a (sufficiently small) portion of the value of the company, let us say a fraction
1 − . At this point the usurer enters the scene. While the bank goes through legal
channels to recover its credit, the usurer has his own debt-recovery “technology”, which
reduces the problem of asset diversion. The usurer also derives a private benefit from the
continuation of activity in t = 1, as we shall see later on. The probability of renegotiation
is therefore higher with the usurer than with the bank: in t = 0. If the debtor has a private
benefit from continuation12 that is not even captured by the usurer, this higher probability
of renegotiation will have a value for the debtor. He will therefore be willing to pay a
higher interest rate in exchange for this.
Let us now, in a dynamic setting,13 consider an agent with the following opportunity:
1. In period 0, he invests I
2. In t = 1, he obtains P with probability p and 0 with probability 1 − p. The moves
of nature are observable.
3. If he does not fail before, in t = 2 he obtains H , assured.
The investment not only has a positive expected value in t = 0 but, since it brings
an assured, high pay-off in t = 2 H , it has a positive value regardless of whether the
investment is realized in t = 1. This structure of the investment therefore tends to cover
the possibility of a liquidity crisis in the short term, even though the value of the project
is positive in the long term.
The agent does not have I and must therefore seek financing: at the most he can
furnish collateral equal to C < I. But there is a problem of asset diversion. As in Hart
and Moore (1988), the investor can appropriate the future cash flows. As observed earlier,
this has various implications (which will be examined in depth later on):
1. no one is willing to finance the investment with risk capital, because the investor can
always simulate zero or very low profits;
2. no one is willing to finance the investor long-term (until t = 2), because in this case
the entrepreneur, rather than repay the loan, would decide to apply for bankruptcy
(for H sufficiently large to cover collateral C) capturing almost all the pay-off.
3. A short-term loan is therefore not precluded. If, in fact, it is true that:
1 + rI − C1 − p
P≥
p
the lender may demand an interest rate that gives him profits greater than or equal to
zero and, in the case of positive earnings and H sufficiently large, the creditor will be
willing to pay. If he does not pay, the creditor would demand bankruptcy and would
lose H .
In the model there are two alternative sources of credit: banks or usurers. The bank
market is perfectly competitive (thus bank profits are ex ante nil) and the bank raises
the principal paying interest rate r. Let us then consider the presence of a usurer: he,
too, raises capital at rate r. To disburse the loan, both creditors sustain a fixed cost equal
to N, which can be thought of as the cost of acquiring information and processing the
206 MASCIANDARO

paperwork. The usurer, however, can capture private benefits of B from the entrepreneur,
if the investment continues. This is a general assumption that reflects various aspects of
the usurer’s nature:
1. usurers can derive benefits by influencing the economic activity, because this ensures
them the possibility of laundering money;
2. usurers definitely have a greater capacity for intimidation than banks and thereby a
reduced problem of asset diversion.
In effect, this assumption is similar to the one made in section 1, where the usurer
had a higher valuation of the collateral than the bank: in this case the collateral is the
expected long-term profit from the investment.
Furthermore, doing business with usurers, i.e., with an illegal agent, has a cost to the
investor of : the greater his aversion to illegality, the greater this will be variable.
Let us assume that, because it is difficult to appropriate the future income generated
by the investment described above, in the case of bankruptcy the bank is only able
to appropriate a portion 1 −  of the pay-off. In this case, the bank will decide to
renegotiate the loan in t = 1, if the profit expected in t = 2 (subject to event P =
0) is greater than that of bankruptcy in t = 1. When event P = 0 occurs, the loan is
renegotiated, the bank derives a profit of B renegotiation = 1 − H + C − 1 + r2 I or the
fraction of profits from the investment it is able to recover, plus the collateral, net of the
opportunity cost of the principal for two periods.
If, on the contrary, the renegotiation is not accepted, the bankruptcy will take place
in t = 1, and the pay-off to the banker will be B bankruptcy = C − 1 + rI. The creditor
will therefore decide to renegotiate the credit only if B P =0 = 1 + r−1 B renegotiation −
B bankruptcy = 1−
1+r
r
− 1+r C < 0, which can be rewritten as:
rC
(10) 1 −  <
H
Expression (10) lends itself to easy interpretation. If the banker decides to force the
investor into bankruptcy in t = 1, he obtains the collateral one period earlier than in the
case of renegotiation, so the opportunity cost of deferring this decision is equal to the
interest he would lose: rC. In return, if it is decided to renegotiate in t=2, he obtains
a higher pay-off of 1 − H . So renegotiation occurs if 1 − H > rC. Note that for
 = 1 (total asset diversion) there is never renegotiation, whatever H and C are. Given
(10), we can compute debtor’s expected profit in t = 0:
  

 P −R H C 1 − H
p
 + − 1 − p if r >

t=0  1+r 1 + r 2 1+r C
(11) =  


 P −R H H − C 1 − H
D 
p + + 1 − p if r < 
1+r 1 + r 2 1 + r 2 C
In (11) R1B eR2b represent the payment the debtor must make to the bank at period 1
whether there is renegotiation or not. It is easy to demonstrate that R1B < R2b .
In fact, if there is no renegotiation the bank has zero profit for pR + 1 − pC =
1 + rI + N ; therefore
I1 + r − 1 − p + N
R1B = 
p
IN OFFENSE OF USURY LAWS 207

When there is renegotiation the profit is zero if pR + 1−p

1+r
1 − H + C = 1 + r×
I + N ; therefore
I1 + r − 1−p
1+r
1 −  + C + N
R2B = 
p
This last expression can be rewritten as:
 
I1 + r − 1−p
1+r
C 1−
C
+1 +N
2
RB = 
p
From the condition of non-renegotiation by the bank (10), therefore:
 
I1 + r − 1−p
1+r
C 1−
C
+1 +N I1 + r − 1−p
1+r
C1 + r + N
2
RB = < = R1B 
p p

In r ∗ = 1−HC
there is discontinuity, because in this case the optimal choice of the
bank changes in period 2: ex ante the optimal choice of the creditor is endogenized and
depends on the model parameters.
The problem of the usurer is different: on the one hand, he is more interested in
continuing the project, since he received private benefits from it; on the other, however,
the debtor sustains costs in renegotiating with the usurer that, as we said, increase as his
aversion to illegality increases. The usurer rinegotiates only if U P =0 = 1 + r−1 ×
U renegotiation − U bankruptcy = 1−
1+r
r
H + B − 1+r C > 0, which can be rewritten as:
rC − B
(12) 1 −  > 
H
Given the renegotiating choice of the two types of investors (bank and usurer), when will
the debtor prefer the usurer? Naturally the debtor’s choice will depend on the interest
rate to be paid in t = 1, unless there is illiquidity. The usurer must satisfy two constraints.
On the one hand, he must the earn reserve utility ū: though assuming ū = 0, this imposes
a minimum value of RU . On the other hand, however, the usurer must be more attractive
than the Bank. This, of course, imposes a maximum value of RU .
A figure could be drawn, in which in addition to the pay-off of the debtor financed
by the bank there should be also the pay-off of the debtor financed by the usurer under
the assumption (provisional, as we shall see) that the usurer demands a rate equal to
that of the bank RU = RB .14 The chart shows clearly that RU = RB is not equilibrium:
per rC−B
H
< 1 −  < rC−BH
the pay-off is lower with the bank than with the usurer and the
latter would be selected. But this is also true if the usurer requested a slightly higher
rate. Furthermore, if the constraint of participation was satisfied, it will be even more so.
In equilibrium the usurer chooses the maximum RU that makes the debtor indifferent.
The same is true the external intervals. If the constraint is satisfied in a non-stringent
manner, then the usurer will be willing to reduce R to attract “customers.” In equilibrium
we can say:
Proposition 3 Given the assumptions of the model, it is true that:
rC−B
(a) when 1 −  < H
there is never any usury.
208 MASCIANDARO

(b) when 1 −  > rCH

there is usury and the usurer will demand an equilibrium interest
rate equal to
  
 1 1 − p H 1 + r rC − B rC
R
 B + − if ≤ 1− ≤
p 1+r 1−p H H
RU =

R2 − 1 + r 

if 1 −  ≥
rC

B
p H

where R1B and R2b are the interest rates demanded by banks for the respective inter-
vals.
Proof: Proceeding in order:
(1) If it is true that 1 −  < rC−B
H
, the debtor prefers the usurer if:
   
P − RB1 H C P − RU H
p + − 1 − p − p +
1+r 1 + r2 1+r 1+r 1 + r2
C
+ 1 − p + ≤ 0
1+r
so if:
pRU − R1B 
(1A) + ≤ 0
1+r
But the restriction on usurer participation, that his expected profits be positive, implies
that
I1 + r − 1 − pC
RU > = R1B
p
But then, given this relationship, the left side of the inequality (1A) is the sum of the
two positive addends that is never zero. (1A) is never verified, there is no usury.
(2) Comparing the pay-off of the debtor between the two sources of financing in the
range rC−B
H
≤ 1 −  ≤ rC
H
, we note that the usurer is preferred if

pRU − R1B  1 − p
− H +  ≤ 0
1+r 1 + r2
The constraint is certainly satisfied; in fact, it requires that
1−p B
RU ≥ R1B −
p 1+r
The rate demanded by the usurer is therefore:
 
1 − p H 1 + r
RU = R1B + − 
p 1+r 1−p
rC
(3) For 1 −  > H
we proceed as above.
IN OFFENSE OF USURY LAWS 209

In the range 1 −  > rC H

the bank always elects to renegotiate. It is therefore efficient to
obtain credit in the official channels, since cost  need not be sustained. If the usurer
wishes to compete with the bank, he must accept an interest rate on short-term loans
(Ru ) lower than the bank rate, so as to compensate for cost . It may suit the usurer
to do this, because it can earn him private benefit B. For lower values of (1 − ) the
problem of asset diversion is such that the bank decides to force the illiquid (but still
creditworthy) into bankruptcy in t = 1. In this case, however, two cases may occur: when
the verifiability of company value is extremely low (1 −  < rC−B H
) neither the bank nor
the usurer choose to renegotiate. The usurer loses his advantage with respect to the bank
and is less efficient (due to the cost of illegality), and so he will never be chosen. In the
range rC−BH
≤ 1 −  ≤ rCH
the most interesting phenomenon occurs. On the one hand, the
usurer remains less efficient because he always implies a cost  for the debtor; but on
the other, the usurer has an important advantage: he guarantees renegotiation. Since the
debtor continues to have a private benefit from renegotiation (due to the problem of asset
diversion he enjoys, in all cases, H in t = 2), the usurer may charge for this “service”.
From this we understand why when  is sufficiently small the interest rate demanded by
the usurer in equilibrium is higher than that of the bank.15 The range of the parameters
in which this equilibrium occurs can also be quite broad: it all depends on the dimension
of B; for a sufficiently large B it can be considered “the norm.”
One important assumption of the model deserves a more thorough look. The usurer
obtains private benefits only from the continuation of the loan from t = 1 to t = 2, or
from a long-term financing relationship. This assumption, highly plausible and supported
by practical experience, has important implications. In particular, thanks to it, in the
period t = 1 the usurer would never agree to take borrowers away from the bank, or to
refinance borrowers for whom the bank does not agree to renegotiate credit. If the Bank
does not find it cost-effective, then the usurer, without private benefits, will not find it
cost-beneficial either. Thus the debtor in t = 0 is aware that although he is choosing
short-term financing between bank and usurer, this choice has long-term repercussions:
if he selects the bank and there is illiquidity, there will be renegotiation and he will not
be refinanced by the usurer, so he will not reach period t = 2; while if had selected the
usurer immediately, there would have been renegotiation. Once the source of financing
is chosen, it can no longer be changed, so the debtor’s choice must be strategic.
It is therefore natural to wonder at what point the results seen above are still valid if
the borrower is allowed to change source of financing in t = 1: i.e. choose the bank and
then, if things go awry, the usurer. In any case it is true that:
Proposition 4 Even if we assume that the usurer derives private benefits even in the
short-term relationship, and the debtor can change source of financing in t = 1, there
is always a range of parameters in which the debtor chooses to seek financing from the
usurer in t = 0 at a higher rate than that of the bank.
Proof: The exchange of credit between bank and usurer in t = 1 takes place at the
“price” (Nash’s solution) P = 21  1−H+C+B
1+r
− C . It behooves the usurer to assume the
credit in t = 1 if 21  1−H+C+B
1+r
> N + 1
2
C, which can be rewritten as:
21 + rN + 21 C − C − B
1− > ="
H
Since " > rC−B
H
for each N > 0, then the range rC−B
H
< 1 −  < " is never empty.
210 MASCIANDARO

The reason Proposition 3 is true is simple. As we saw in paragraph 2, the disbursement

of loans has a fixed cost to the lender of N (due to the acquisition of information, the
paperwork, etc.). If the credit is disbursed in t = 0, this fixed cost for “opening the
account” is sustained in t = 0 and has little or no effect on the choice in t = 1. If, on
the other hand, the source of financing is changed in t = 1, the marginal cost of the
renegotiation increases by N: so the renegotiation becomes more difficult, and in some
cases impossible, in t =1. For this reason the debtor will want to “do business” directly
in t = 0 with the one who guarantees renegotiation, the usurer.
There are various other intuitive reasons for suspecting that the analysis may remain
valid, beyond the case seen above, in which the private benefits depend on the period
of the financing. The most important and economically significant, perhaps, is that of
inefficiencies in the transfer of the credits. If there is illiquidity and the bank does
not renegotiate the loan, two things can happen: (a) it decides to force the company
into bankruptcy and obtains C − 1 + rI< 0. (b) it ‘sells’ the credit to the usurer.
Theoretically the bank should be open to option (b) if the usurer pays " = C + # for
any #>0, but this would mean that the bank ‘pays’ the usurer to obtain the credit.16
It would be worthwhile, because it costs less than bankruptcy. This scenario sounds
unrealistic. The most typical scenario could be where the debtor asks the usurer for
money to repay the bank and save him from bankruptcy. Especially for small debts,
the bank may be willing to avoid bankruptcy only if it is repaid in such a way that it
suffers no losses RB ≥ 1 + rI. In this case the usurer might not accept the ”deal.”
More simply, it is plausible to believe that the “sale” of the credit involves a cost: the
higher this cost, the lower the probability that the usurer will agree to assume the loan
in t = 1. This point reveals a second important aspect of the analysis on usury: the link
it has with the efficiency of the financial market. When the market is not efficient, the
debtor must expect it will be impossible to “change horses in midstream.” So he must
make a strategic decision in t = 0: select the usurer—even though it is not beneficial in
the short term, because the interest rate demanded is too high—with a view to future
benefits (renegotiation).

3. On the difference between illegal and legal contracts:

What was Shylock’s nature?

The theoretical analysis just presented helps to clarify the basic difference that exists
between the activity of banks and usurers. This difference is even more evident if we
apply our model to recount—in an economic, original and, we hope, intriguing manner—
the story of the most famous usurer of literature, Shylock, protagonist of one of the most
famous works of the Bard from Stratford-on-Avon.
In The Merchant of Venice we have an economic agent, Antonio, who to help his
close friend Bassanio decides for the first time17 to contract a debt of three thousand
ducats, for three months, sure to have future income, the proceeds of his commerce by
sea, absolutely sufficient. The expected income for coverage can reach a maximum value
of eighty-one thousand ducats.18 But the expected income is by definition uncertain,
since the ships of Antonio are on a voyage,19 and they could be shipwrecked. In the
IN OFFENSE OF USURY LAWS 211

most pessimistic assumption of collective shipwreck, we would have zero income. For
simplicity’s sake, let us consider only these two events.
Based on the theory of optimal loan contracts, a 3% probability of the favorable
event are sufficient to make the financing project worthy. By the same token, Antonio is
extremely tranquil, since he has diversified the risk.20
The indebt himself, Antonio then applies to the hated, ever mistreated Shylock,21 Jew
of Venice. What is Shylock’s profession? He lends money, seeking to have it back plus
interest; therefore we usually think he acts like a banker. Let us assume, to continue
our tale with simplicity, that many Jews loaned money at that time in Venice, such
that a competitive market existed. If Shylock considered Antonio a normal customer, he
would calculate the probability of the occurrence of various events that would conditions
Antonio’s ability to meet his commitment.
We must therefore determine the objective probability—i.e. agreed by both Antonio
and Shylock—that the ships return. We can imagine, apart from the subjective hopes in
one direction or the other, that the probability of this event is, for example, 80%. Then,
still applying the theory of optimal contracts, Shylock would demand the repayment of
3,750 ducats, which corresponds to an interest rate of 25%.
But Shylock has no intention of acting like a banker with Antonio. The hate he harbors
for him22 drives him to seek to gain possession of the collateral that interests him most:
the life of the merchant of Venice. So Shylock’s proposal to Antonio is the following:
“Go with me to a notary, seal me there your single bond; and, in a merry sport, if you
repay me not on such a day, in such a place, such sum or sums as are express’d in
the condition (editor’s note: the 3000 ducati), let the forfeit be nominated for an equal
pound of your fair flesh, to be cut off and taken in what part of your body pleaseth me.”23
Shylock is transformed from a banker into a usurer: he offers a contract in which
the desire to gain possession of the collateral is reflected in highly favorable monetary
conditions: the interest rate, in fact, is zero! That particular good as collateral, which
under normal circumstances would likely have no value for a banker, assumes that illegal
or iniquitous surplus value for Shylock with Antonio that represents the peculiarity of
conduct of a usurer with respect to that of a banker. Shylock is therefore both, according
to the contract he offers. And note that extinguishing the life of Antonio has a value for
Shylock that is not only emotional but also rational: in fact, he would be eliminating a
party who always lends at zero interest.24
It might be interesting to compute what monetary value Shylock implicitly assigns to
a pound of Antonio’s flesh. Applying the usual formula of contracts, we discover that
Shylock implicitly assigns a value of 3,000 ducats to one pound of Antonio’s flesh. But
there is more: whatever the probability assigned to the favorable event, the value of the
collateral does not change, nor does the value of the repayment change.
This would not occur if Shylock acted like a banker: any variation in the uncertainty
would vary the interest rate, and with it the value of the repayment, because that is the
objective of a banker. But Shylock is not seeking repayment but the collateral, and this
is the only contract his is interested in.25 So he is still offering the most advantageous
conditions possible: interest rate zero.
Note, in fact, that Antonio accepts Shylock’s proposal with enthusiasm, judging
it extremely generous.26 A zero interest rate implies zero risk; i.e. the certainty for
Antonio—and this is at the limit of verisimilitude—but also for Shylock that the ship
212 MASCIANDARO

will return, and that the debt will therefore be repaid. A debt repaid is the objective of
a banker; but Shylock in this contract is a usurer, and his objective is that the debt not
be repaid so that he can take possession of the collateral.
That seizing the collateral is Shylock’s sole purpose is further demonstrated by:
• the joy with which he greets the news of the loss of Antonio’s ships;27
• his obstinate refusal of much greater sums for repayment in exchange for cancellation
of the collateral clause. Not only did Shylock first not accept 6,000 ducats (which
would have represented an interest rate of 100%), then 9,000, but he also stated that
he was prepared to refuse 36,000 ducats.28
We are all familiar with the conclusion to the story;29 the wording given by Shylock
to the loan contract did not permit him to achieve his purpose, pain intolerable costs.30
Shylock becomes a banker again, seeking to have back at least the principal loaned.31
But he is now completely ensnarled in the tangles of the law, loses his religion and the
drama becomes comedy.

4. Conclusions

Based on the foregoing economic analysis regarding the nature and characteristics of
usurious credit contracts, a few assessments could be formulated regarding anti-usury
laws characterized by interest rate ceilings, i.e., in which a loan contract is usurious
when it contemplates excessively onerous interest. The conclusions are clear: it is more
effective to combat usury by improving the laws and law enforcement to better protect
property rights, rather than introduce rate ceilings In any case, the usury market can
be reduced but not eliminated, since it is a meeting place for particular borrowers and
lenders of funds.
An approach based on ceilings and rates could be potentially ineffective in the war
against usury, unjust for the definition of legal credit contracts and inefficient for the
operation of the banking markets, as well as involutional with respect to the current trend
in European bank regulation.
In the first place, the usury market prospers thanks to parties who request funds from
parties in a position to provide them. Is it reasonable to believe that by administratively
blocking only one of the possible characteristics of a loan contract (initial conditions,
collateral characteristics, mode of payment, renegotiation mechanisms, etc.) we can truly
block the illegal market in question? Nor do we doubt that tensions in the financial
structures of companies and households, insufficient efficiency in the offering of banking
services, social hardships and widespread propensity to illegality create potential user
pools for parties—the userers—who will be skillful in circumventing the restrictions and
safeguards erected to protect legal credit contracts.
On the contrary: the improbable gains in effectiveness would probably be accompanied
by losses in terms of fairness and efficiency.
In fact, making the nature of a contract coincide with the level of its interest rate
potentially opens the door to pernicious claims and litigation on legal loan contracts that
had nothing to do with usury, as properly defined.
Let us just think of how many cases of mediocre entrepreneurs, actual and potential, or
imprudent consumers, actual and potential, can find protection in a law that erroneously
IN OFFENSE OF USURY LAWS 213

concentrates on only one aspect of the contract, extending the phenomenon of false
accusations of usury.
Lastly, although analyzing the rationing resulting from the introduction of restrictions
on interest rates is not the subject of our study, we should at least mention an additional
result, now an acquired part of economic analysis: imposing administrative restrictions on
lending results in the inefficient rationing of the marginal and weakest persons. The more
stringent the rate ceilings, the stronger the effects of rationing, and thus the potential
inefficiency.

Acknowledgments

Full Professor of Monetary Economics; Paolo Baffi Centre for Monetary and Financial
Economics, Bocconi University, Milan and Department of Economics, Mathematics and
Statistics, Lecce University. The author wishes to thank, without implicating two anony-
mous referees. The author also thankfully acknowledge financial support from Paolo
Baffi Centre.

Notes

1. For an overview, see Baudasse’ (1993).

2. This approach is the basis for empirical works on the effects of anti-usury legislation: see Blitz and Long
(1965), Boyes (1982), Brucker (1977), Crafton (1980), Greer (1977), Ostas (1976), Peterson (1977), Robins
(1974), Villegas (1982).
3. This model is a general framework of the “usury specialness” approach introduced in Masciandaro (1997) in
a static version and developed in Cifarelli, Masciandaro, Peccati, Salsa and Tagliani (2001), using stochastic
calculus, and in Masciandaro (2001) using a dynamic approach, and finally enriched in Masciandaro and
Porta (1997) and Masciandaro and Battaglini (2000) through empirical analysis.
4. See Bester 1993.
5. The paper presents here a simplified version of the static model. The working hypotheses describe a general
model of usurious credit that includes as specific cases not only the classic models with rationing but
also the specific case studied in Masciandaro (1997), which analyzes (a) only the financing of investment
projects, (b) without considering the difference between banks and usurers in terms of risk premium on
the debtor, (c) considering all debtors homogeneous.
6. As will be evident further on in this paper, considering the risk premium constant rather than varying, for
example, with the amount of the loan, does not alter the conclusions.
7. It can be demonstrated that by modifying the assumption of competitive markets, the results obtained are
confirmed: see Masciandaro (1997).
8. Bester (1993).
9. On this point various models of debt theory in a context of incomplete markets have been developed: see
Hart and Moore (1988) and Hart (1995).
10. Note the assumption that the moves of nature are observable: this is a highly plausible assumption that
simplifies the results, but it is not essential for the purposes of the model. If this occurs, the creditor can
distinguish in t = 1 when there is insolvency due to nature or when there is no insolvency but the debtor
does not wish to pay, taking advantage of the non-verifiability of the assets.. Consequently, it does not
behoove the debtor to lie, because he would certainly be forced into bankruptcy. This assumption could be
eliminated by introducing uncertainty, in the mind of the debtor, about the parameters of the bank. In this
case, even if the parameters were such that faced with a declaration of insolvency the bank still decided to
renegotiate, there would be a risk for the debtor on the parameters, and thus a probability of bankruptcy.
214 MASCIANDARO

If the risk is sufficiently high, and particularly if the expected profit in t = 2 is sufficiently high, it would
be best not to lie.
11. In this case the threat of the bank continues to apply, so the problem of the verifiability of the pay-off
is resolved. Naturally, to loan the money, the bank will demand a higher interest rate (for this reason the
pay-off in the intermediate period must be sufficiently high, or the amount of the debt proportionately
low).
12. This point will be discussed in greater detail later. Let us consider for now that bankruptcy in t = 1 results
in a “crash” in the value of the entrepreneur’s human capital (not only loss of credibility but also the
legal consequences of the bankruptcy). Postponing this loss of human capital can have an extremely high
value, especially if the problem is viewed on a horizon of more than three periods: because investment
opportunities are lost.
13. The dynamic approach was introduced in Masciandaro (2001).
14. Therefore Ru = R1B if r > 1−HC
and Ru = R2B if r < 1−HC
.
H
15. Note from proposition 2 that this occurs if  < 1+r : or if the cost of “doing business with the usurer” is
lower than the expected value of the private benefit of the debtor deriving from continuation. We must
remember that H can assume high values, considering that it also includes the value of the reputation of
the debtor’s “human capital.”
16. In fact " − 1 + rI = C + # − I1 + r < 0 for # sufficiently small.
17. Atto I, Scene III: Antonio to Shylock: “   although I neither lend nor borrow by taking nor by giving of
excess, yet, to supply the ripe wants of my friend, I’ll break a custom.”
18. Atto I, Scena 3, Antonio to Bassanio: Why, fear not, man; I will not forfeit it: (   ) I do expect return of
thrice three times the value of this bond.
19. Atto I, Scena 1, Antonio to Bassanio: “Thou know’st that all my fortunes are at sea; Neither have I money
nor commodity to raise a present sum.”
20. Atto I, Scena 1, Antonio to his friend Salarino: “(   ) I thank my fortune for it, My ventures are not in
one bottom trusted, nor to one place; (   ).”
21. Atto I, Scena 3, Shylock to Antonio: “Signior Antonio, many a time and oft In the Rialto you have rated
me about my moneys and my usances: (   ) You call me misbeliever, cut-throat dog, and spit upon my
Jewish gaberdine, and all for use of that which is mine own.”
22. Atto I, Scena 3, Shylock speaking of Antonio: “I hate him for he is a Christian, But more for that in low
simplicity he lends out money gratis and brings down the rate of usance here with us in Venice. If I can
catch him once upon the hip, I will feed fat the ancient grudge I bear him.”
23. Atto I, Scena 3.
24. See the quote in note 15.
25. Act I, Scene 3: Shylock to Antonio, regarding his offer: “(   ) If he will take it, so; if not, adieu; and, for
my love, I pray you wrong me not.”
26. Act I, Scene 3: “Content, i’ faith: I’ll seal to such a bond and say there is much kindness in the Jew.”
27. Atto III, Scena 1: Tubal, a Jew of Venice, to Shylock: “Yes, other men have ill luck too: Antonio, as I
heard in Genoa,–    (   ) Hath an argosy cast away, coming from Tripolis.” Shylock: “I thank God, I
thank God! Is’t true, is’t true?” (   .) “I thank thee, good Tubal: good news, good news! ha, ha! (   ).”
Tubal : “There came divers of Antonio’s creditors in my company to Venice, that swear he cannot choose
but break.” Shylock: “ I am very glad of it: I’ll plague him; I’ll torture him: I am glad of it.”
28. Atto IV, Scena 1. Note that Shylock’s refusal to accept 36,000 ducats to discharge the obligation in
exchange for waiving the collateral does not conflict with the fact that when the contract was stipulated
he explicitly assigned a value of 3,000 ducats to that collateral. 3,000 ducats was a sufficient value for
Shylock to offer Antonio the best possible contract for him (interest-free), in perfect competition with the
other lenders, and to have the hope of taking possession of the pound of flesh (whose value for the usurer
coul theoretically be infinite). Shylock is hungry for revenge but rational.
29. Act IV, Scene 1: Portia to Shylock: “Tarry a little; there is something else: This bond doth give thee here
no jot of blood; The words expressly are ‘a pound of flesh:’ Take then thy bond, take thou thy pound of
flesh; but, in the cutting it, if thou dost shed one drop of Christian blood, thy lands and goods are, by
the laws of Venice, confiscate unto the state of Venice.” (   ) “Therefore prepare thee to cut off the flesh..
Shed thou no blood, nor cut thou less nor more but just a pound of flesh: . if thou cut’st more or less (   )
Thou diest and all thy goods are confiscate.”
IN OFFENSE OF USURY LAWS 215

30. See the previous note.

31. Act IV, Scene 1, Shylock: “Give me my principal, and let me go.”

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