Part 2: Why formal loans may never substitute informal loans
In the previous blog, we discussed about the significance of informal finance in the lives of slum dwellers and outlined some of the legislations related to moneylending activities issued by various states in India. This blog discusses why informal lending market is sticky and not easy to substitute with formal lending; and deliberates on what could be the way forward in resolving this.
One of the traditional challenges of the financial inclusion agenda has been in curbing the market for informal finance (particularly loans from moneylenders) through introduction of formal financial services in remote or previously underserved areas. In the presence of exploitative interest rates and offensive recovery practices, there has been sustained conversation around providing financial access to hitherto unbanked population segments through means that are legally binding, protect consumers and ensure fair conduct by service providers. Policy makers have believed that with reasonable time, efforts to augment the presence of institutional finance will substitute informal finance, and that this will be driven by a steady shift in consumer’s preference for formal finance. However, even as such efforts may be inarguably well-intentioned, there are studies that show that preference for informal finance does not decrease with the presence and access to institutional finance.
Such studies have found that informal credit markets often display patterns and features that are not commonly found in formal structures, such as i) loans are often advanced on the basis of oral agreements rather than written contracts, with little or no collateral, ii) the credit market is usually segmented, marked by long-term exclusive relationships and repeat lending, iii) interest rates are much higher on average than bank interest rates, and also show significant dispersion, presenting apparent arbitrage opportunities, iv) there are significant inter-linkages with other markets such as land, labour or crop and v) significant credit rationing, whereby borrowers are either unable to borrow all they want, or are unable to borrow at all (i).
One of the landmark theories that explain credit rationing in markets with imperfect information has been authored by Stiglitz and Weiss (1979)(ii). This strand of literature discusses that in presence of imperfect information, a competitive loan market may be characterized by credit rationing. The theory explains that even in the case of observationally identical borrowers, some receive loans and others do not. The ones who are refused are often willing to pay more than the market interest rate. However, banks tend to not respond to excess demand for credit even when borrowers are willing to pay a higher interest rate. This is primarily for two reasons. Banks may feel that a) at a higher interest rate, risk-averse borrowers would not have much incentive to borrow, thus leading to a pool of applicants with higher risk to default on loans or b) higher interest rate would lead borrowers to invest in riskier projects. In this process, credit rationing (by limiting the number of loans the bank will lend) will be a natural outcome of screening borrowers, and as a fallout, borrowers will borrow from the moneylenders.
In addition to this, studies have shown that the presence of institutional credit can in certain cases bear an adverse effect on informal credit. Infact, multiple cross village comparative studies have found that the rate of interest on private credit was steeper in those villages where institutional finance had large presence (iii). The rationale for the escalating cost of private credit in the informal market (comprising moneylenders) may be attributed to multiple interdependent reasons. For instance, in a study conducted in a village of Uttar Pradesh (Palanpur), it was found that even though formal institutions are responsible for eighty per cent of accumulated debt, fresh borrowing was much lower- indicating a constant rise in private services of lending. Furthermore, accumulated debt creates a barrier to fresh borrowing from any lending institution, thus creating a loop within the system. In such situations, supplementary capital from money lenders with flexible repayment scheme is more easily available.
Contrary to our expectations, moneylenders often aid smooth recovery for bank credit. P.B Ghate, an expert on the mechanics of informal finance found that in Bangladesh recovery agents help borrowers roll over bank loans for a fee, after which they are eligible for a fresh loan. It was observed that borrowers were willing to pay the fee for accessing fresh loans (iv).
As we become cognizant of the fact that institutional finance may never completely replace non-institutional finance, should banks stop expanding to areas with high presence of private lending or is there still scope of fostering linkages between the two- given the comparative advantages of either? To begin with, linkages could be designed to use informal financiers as facilitators rather than direct financing institutions. The positive outcomes of building linkages between the two could be a) better outreach of potential customers with reasonable debt repayment capacity b) better debt to GDP ratios in cities of the state (and not only the capital city), c) enhancement in ability to screen low-income customers efficiently by using household-level information based on moneylenders’ familiarity of local families d) better knowledge of emergency situations in various geographical pockets and the need for small-ticket loans to overcome these situations e) provision of credit at a rate lower than the moneylender and, f) curbing of overheating and over indebtedness by checking informal and formal credit history of low-income households.
However, there are several inevitable challenges to building linkages between formal and informal sources of finance as well. For instance, using moneylenders as business correspondents or agents of banks may not always ensure accurate monitoring of actual end use of the loan by borrowers or warrant fair recovery practices. In addition, there could be also be a lingering danger of political interference in the daily functioning of banks due to their involvement at the grassroot level. Further, channelling of credit through moneylenders could inadvertently boost their (moneylender’s) own lending business, thereby adding to existing exploitative practices.
In my fieldwork in the slums of Chennai, majority of the moneylenders where neither registered nor regulated. Given that most states have passed legislation related to money lending several years back, it is necessary that these regulations are revisited and reviewed by the authorities in every state. In my opinion, any step towards building linkages between formal and informal financial services will require identification, registration, certification and legalization of non-institutional financial services. However, the first step towards this would lie in working towards framing suitable and effective legislations, particularly for the business of moneylending and broadly for other types of informal finance.
(i) Ghosh, P., Mookherjee, D., & Ray, D. (2000), “Credit rationing in developing countries: an overview of the theory.” Readings in the theory of economic development.
(ii) Stiglitz, J. E., & Weiss, A. (1980, August). “Credit rationing in markets with imperfect information, Part II: Constraints as incentive devices.” In 4th World Congress of the Econometric Society.
(iii) Bhaduri, A. (2011). “A contribution to the theory of financial fragility and crisis.” Cambridge Journal of Economics
(iv) Ghate, P.B. (1992) Informal Finance: Some Findings from Asia. Hong Kong: Oxford University Press