Informal Finance Is The Theory Followed While Lending Money

Almost all moneylenders follow the theory of informal finance though formal finance coexists with it. There are specific models that analyze such coexistence especially in an underdeveloped credit market scenario.

  • Formal finance theory is followed by the formal or conventional banks that you are so used to access. These banks supposedly have unlimited funds to offer and have a lot of rules and strict regulations to follow. Somehow, it is felt that these banks are not able enough to govern the use of credit.
  • On the other hand, the informal lenders are more efficient in preventing any non-diligent behavior but however they lack volume of capital needed for it which is where they fall behind the formal banks always.

The obvious and natural inference is that in the modern money lending market both formal and informal credit theory exists that either substitutes one another or complements each other.

With careful and in-depth analysis of the model also clarifiesthe reason for the increase and prevalence of the weak legal institutions. It also tells a lot about the influence and usefulness of informal finance in a few specific markets where it is more and comparatively much less in others. It also tells about a few other things such as:

  • Why segmentation persists in a financial market
  • Why the informal interest rates are so high as compared to the formal market and
  • Why it is highly variable inside the same sub-economy.

This is primarily due to the low levels of income among the people in an underdeveloped area. It is seen that poor people need funds more frequently and they either obtain it from informal credit sources such as borrow from the proper and formal financial sectors.

Sometimes they are found to borrow from both at the same time. Research report says that more than 70% of all borrowers have multiple debts and usually get credit from both formal as well as informal sectors at the same time.

The issues and concerns

However, the informal financing arrangements raise a large number of issues that needs to be taken care of in order to prevent people from falling into the debt trap. It is required to find out answers to several important questions such as:

  • Why do these borrowers take informal loans even knowing that there are so many formal banks existing in the market
  • Why do so many people obtain funds from both these financial sectors at the same time
  • Whether there is any causal link between the level of income of the borrowers and the institutional development of informal lending
  • How to deal with this connection if there is any?

All these answers will point towards the empiricalimportance of the coexistence of formal and informal finance that has not received the required attention till date.

Working on microfinance

The informal setting of money lending has given rise to microfinance and therefore it is very much important to shift the focus from the theoretical work on microfinance to the more practical issues and effects on the money lending market.

According to the theory of informal finance, the main assumptions are the first and foremost things that should be looked into. These primary assumptions can be summarized as follows:

  • First, the literature on the consequences of institutions on economic presentationmust be looked into. This will ensure whether or not there is any need to provide any legal protection to the formal banks to make sure that credit is available.
  • Second, research says that the reasons for the limitation of supply of funds are that the borrowers divert their bank loansbased on forecasts of moral hazards rather than actual results. Another reason for such limitation in supply of funds is the weaker contract enforcement that inevitably increases the worth of such diversion.
  • On the other hand, it is seen that the informal lenders are more efficient in monitoring the borrowers by offering credit to only a selected group of known clients. As a result, they can cash on the social sanctions and social ties that invariably result in inducedinvestment.
  • Moreover, while the conventional banks have unlimited access to funds, the informal lenders often find their resource constrained which leads to financial intermediation being held up. This is not due to the lack of informed local agents but is certainly for the lack of local intermediary capital, as found through a study.
  • Informal credit is usually offered by landlords, shopkeepers, professional moneylenders, and traders and consequently they obtain bank funds to provide the money to service the financing needs of their borrowers. This fact is further substantiated by the study report that reveals that three quarters of formal credit totals the liabilities of the informal sectors.
  • Often, the less developed economies are characterized as uncompetitive and in particular the formal banking sector typically hasthe major market power. Given this framework, the informal finance thereby affects the poor people the most when it comes to access to credit in either of the two sectors. In this model, the formal banks are controlled by the inability of the borrowersto commit to use the credit for any productive purposes.

These problems are even more acute not only for the poor people but the agencies as well due to the diversion that invariably increases the size of the loan.

Improving borrowers’ relationship

The model for analysis suggests that with better monitoring tools and mechanisms the informal lenders have the advantage of being able to lend to the bank-rationed borrowers but the fact that they do not have the huge resource necessary to make such loans turn them towards the formal banks for additional funds. This results in the restricted supply of funds in the banks and improper channelizing of the money to unproductive areas for their business.

This easy access and availability of funds by the poor from the informal lenders helps the lenders to establish and improve their relationship with the borrowers as compared to the banks while having their relation improved with the formal banks.

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