Informal Borrowing and Lending in Rural Finance

Topics: Debt, Interest, Loan Pages: 9 (2987 words) Published: May 20, 2012


This paper presents an assessment of informal borrowing and lending in rural finance with a focus on its advantages and disadvantages. It examines a number of issues related to the functioning of rural credit markets, determinants of rural interest rates, why the government intervenes in rural credit markets and how.

Commercial banks and other formal institutions fail to take care of the credit needs of peasants, however, mainly due to their lending terms and conditions. It is generally the rules and regulations of these formal financial institutions that have created the myth that the poor are not bankable, and since they can’t afford the required collateral, they are considered not credit worthy (Adera, 1995). Despite efforts to overcome the widespread lack of financial services, especially among peasants in developing countries, and the expansion of credit in the rural areas of these countries, the majority still have only limited access to bank services to support their private initiatives (Braverman and Guasch, 1986). The development of rural finance with respect to informal borrowing and lending has been a subject of intense debate among scholars in recent times. Pearce (2003) defined rural finance as “encompassing all savings, lending, financing and risk minimising opportunities (formal and informal) and related norms and institutions in rural areas”. Also, Schreiner (2000) defined informal finance as “contracts or agreements conducted without reference or recourse to the legal system to exchange cash in the present for promises of cash in the future”.

Motamen-Samadian (2012) identifies two main sub-sectors in informal markets: the commercial and the non-commercial sector. In her presentation, she maintains that the commercial sector is based on lending from people with having excess liquidity. On the other hand, the non-commercial sector involves loans on an informal basis by friends and relatives (mostly without interest and often arranged on a reciprocal basis). The latter consists of people such as local merchants, landlords, crop traders, professional money lenders and rotating savings and credit association (ROSCA). (Calomiris and Rajaraman, 1998) describe a ROSCA as a voluntary grouping of individuals who agree to contribute financially at each of a set of uniformly-spaced dates towards the creation of a fund, which will then be allotted in accordance with some prearranged principle to each member of the group in turn. It is evident from this definition that it is essentially a private borrowing-lending club. Empirical studies of informal borrowing and lending in developing countries have resulted in a list of common characteristics that are often used to describe informal credit markets in poor countries. Raj (1979) specifies some of such features: • The limited information lenders have, more often than not, hampers knowledge about the borrower and how he spends the money. • Small scale operations are common in these areas. For example, most of them are sole-proprietorships and family-owned businesses. • There is easy entry and exit compared to formal markets owing to low requirements of capital and skills / professional qualifications. • Poor working conditions, lack of knowledge on legal rights leave the players with little or no assurance of equal access to justice. • Interest rates are exorbitant, far above the lenders’ opportunity cost of lending and may vary within each village. • Lenders are often not able to lend more at the going interest rate, but borrowers are willing to borrow more at the going interest rate. Hence, the need to ration credit. • Lack of property rights and no mortgage-able legal titles to land and other assets further weaken access to finance. The informal market operates mainly on the basis of...
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