Informal Credit Markets: A General Overview or the Nexus between Informal Credit Markets and Legal Pluralism

Informal Credit Markets: A General Overview

Informal credit markets are financial markets that operate on a small scale at an individual or group level without following the procedures commonly used in the formal financial sector and without acquiring the organisational structure required by law. Rotating Savings and Credit Associations (ROSCAs) are the most common informal financial institutions that play a significant role in the financial markets of many developing countries. ROSCAs comprise a group of people who decide to meet a predetermined number of times to contribute a fixed amount of money at each meeting and make the total amount available to one member of the group; they continue to do the same until every member of the ROSCA has received once the total sum of the contributions they paid into the ROSCA.

The informal credit market plays a significant role in developing countries' economies (Germidis 1990). Informal credit markets bring to the reach of less fortunate services like credit, insurance, and saving mechanisms that are not otherwise accessible. They help to smooth consumption and minimise the effects of the perils of life, such as illness, loss of a breadwinning family member, loss of a job, or other unexpected accidents. Small- and medium-sized enterprises (SMEs) also mainly depend on informal credit markets to meet their demand for credit. The informal credit market provides full or partial funding to start and expand SMEs in many developing countries.

Features of Informal Credit Markets

The main characteristics of informal credit markets are five-fold. First, they function mainly based on personal relations. People join informal credit markets based mainly on their trust in each other (Rajaram 2001). Based on personal ties, informal credit markets offer advantages; they avoid reliance on complex information or rigid laws and regulations and allow flexibility in operations. Another common feature is that loans are limited and commonly given for a short term with the required flexibility in the payment schedule. Thirdly, informal credit markets are often segmented, especially in rural areas (Aryeetey 2005). The fourth feature of informal credit markets is that they are sometimes interlinked with other markets. The fifth common feature of informal credit markets is that enforcement of obligations commonly depends on social pressure, unofficial laws, and contract laws (Anderson et al. 2009). Finally, it is also widely agreed that the operational costs in informal credit markets are low because there are no salaried employees, and information costs are limited (Guirkinger 2008). Transaction costs are low due to lenders' knowledge about borrowers (Guirkinger 2008).

Explanations for the Pervasiveness of Informal Credit Markets

The question of why informal credit markets exist has challenged scholars. Financial exclusion of people with low incomes is considered to be the most critical factor (Hanedar 2013; Germidis 1990; Aryeetey 2005). The lack of adequate and affordable access to formal credit markets forces low-income people to depend on informal credit markets (Tsai 2004). Researchers argue that lack of collateral, financial literacy, and complicated bureaucracy in formal financial institutions limit access to formal financial services and make them costly for most developing countries' populations (Hanedar 2013). The flexible nature of contracts in informal credit markets, the simplified procedures, and the flexibility in repayment schedules are also relevant factors that sustain informal credit markets alongside formal financial markets as complements and substitutes (Tsai 2004; Pearlman 2010).

 Policymakers have tried to deal with the informal credit market in different ways. The common objective among policymakers has been to bring the actors of the informal credit market to the formally regulated sector of the economy. Easing the procedures and steps required to obtain formal licenses and liberalising the credit market are solutions to narrow the gap between the formal and informal sectors. Subsidising the formal sector to provide adequate services to those excluded from the financial market and setting interest rate caps have been used to control the informal credit market. However, there is no clear policy direction addressing the informal credit market. They remain the dominant and even preferred markets for low-income households in many developing countries.

Conclusions

Finance is considered one of the key inputs needed to create opportunities for people. Individuals, rich or poor, need financial services. Access to financial services is a key element that people need to improve their quality of life. As the state's legal system becomes more centralised and controlled, access to finance has also been limited to people with better information, education and capital. Official financial institutions have become inaccessible to many people. This results from legal and nonlegal conditions that restrict access to finance to those with adequate property to be used as collateral, official documents to identify themselves and meet other criteria to be included by the official financial system. This limitation has been recognised, and international and national development agents, as has the private sector, have taken many positive actions. However, the legal issues that need to be addressed mainly remain untouched. The laws that determine the conditions and the formalities that need to be fulfilled to provide financial services give little attention to the condition of the poor people.

The informal credit markets appear to operate very creatively by blending the local norms and traditions with what they observe from the official laws. The actors in the informal credit markets are not resistant to new norms that they learn from the official laws if they find them practically applicable and serve their purposes well. This incorporation of official laws is the result of many interactions. The fact that some of the leaders and actors in the informal credit markets are educated in official laws and work in government offices has contributed to the incorporation of the official laws into bylaws and into the practices that people use in the informal credit markets. The courts have also helped facilitate interaction between official laws, social norms, and customary laws in two ways. First, when they decide on cases that relate to traditional financial institutions, they usually endorse these norms and usages, thereby giving due recognition to the continuation of the norms and usages. Second, when official laws are applied and the norms and practices in the informal credit markets are rejected, the actors in the informal credit markets respond by amending their laws and practices to avoid problems of enforcing them in courts of law.

The author's book, The Nexus Between Legal Pluralism and Inclusive Finance, can be found here. 

Gebreyesus Yimer is a Visiting Scholar at KU Leuven.