subject: Explanation Of Informal Finance [print this page] Much economic activity in developing nations comes from small-scale producers and enterprises. Most are non-corporate, unlicensed, unregistered enterprises, including small farmers, producers, artisans, trades people, and independent traders operating in the informal urban and rural sectors of the economy. Their demands for financial services are unique and outside the purview of traditional commercial bank lending. For example, street vendors need short-term finance to buy inventories, small farmers require buffer loans to tide them over uncertain seasonal income fluctuations, and small-scale manufacturers need minor loans to purchase simple equipment or hire non-family workers.
In such situations, traditional commercial banks are both ill equipped and reluctant to meet the needs of these small borrowers. Because the sums involved are small (usually less than $1,000) but administration and carrying costs are a large fraction of that for large loans and also because few informal borrowers have the necessary collateral to secure formal-sector loans, commercial banks simply are not interested. Most don't even have branch offices in rural villages, small towns, or on the periphery of cities where many of the informal activities take place.
Thus most non-corporate borrowers have to turn to family or friends as a first line of finance and then warily to local professional moneylenders, pawnbrokers, and trades people as a backup. These latter sources of finance are extremely costly - moneylenders, for example, can charge up to 20% a day in interest for short-term loans to traders and vendors. In the case of small fanners requiring seasonal loans, the only collateral that they have to offer the moneylender or pawnbroker is their land or oxen. If these must be surrendered in the event of a default, peasant farmers become rapidly transformed into landless laborers, while moneylenders accumulate sizable tracts of land, either for themselves or to sell to large local landholders.
Fortunately, in recent years, more reasonable and more reliable forms of informal finance have emerged to replace the moneylender and pawnbroker in some instances. These include local rotating savings and credit associations and group lending schemes. In the case of rotating savings and credit associations (ROSCAs), which can be found in such diverse countries as Mexico, Bolivia, Egypt, Nigeria, Ghana, the Philippines, Sri Lanka, India, China, and South Korea, a group of up to 50 individuals selects a leader who collects a fixed amount of savings from each member.
This fund is then allocated (often randomly) on a rotating basis to each member as an interest-free loan. ROSCAs enable people to buy goods without having to save the full amount in advance. With a ROSCA, individuals can make their planned purchases in half the time, on average. Many low-income people prefer to save and borrow this way, repayment rates are extremely high, and participation is very active.
by: Rashid Javed
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