The Theory Followed By Money Lenders Dealing With Informal Finance

Money lending in this modern world is much more liberal as it used to be before. This is due to the rise in business, both in small as well as large scale sectors. The borrowing capacity of people, as well as business organizations, hasrisen dramatically, thanks to the stable economy and high GDP. Financial institutions have found newer and better ways to lend money and also get it back along with the interest of lending. Even private money lenders are not lagging behind and following suit.

However, it is empirically important to know a few facts before you take on loans from such sources or indulge in lending money. The fact that both formal, as well as informal money lenders, coexist in this modern money market, make it all the more competitive and at times a bit more challenging.

 

Theory of informal finance

There has been a lot of theoretical work and studies conducted on microfinance over the years especially on the theory of informal finance. The fins outcome of these studies and research can be summarized as follows along with the various assumptions of it:

• Firstly, it is the effect of the lending institutions on the country’s economic performance that is taken into consideration exactly in accordance to its literature. There is some sort of legal protection for banks essentially required to ensure both availabilities and recoup of credit. To this end, borrowers may assume ex-ante moral hazard and divert their bank loan. When there is any weaker contract enforcement, it increases the worth of such diversion. This limits the supply of funds. From the other perspective, such diversion has helped the informal lenders in a great way. They can now monitor the borrowers making such diversions and offer them credit especially to a group of known clients. It is the social sanctions and social ties that induce such investments.
• Secondly, the fact that the traditional banks have easy access to unlimited funds and the informal lenders have a constant constraint of resources, there is a need of financial intermediation especially in the financial markets of the developing countries. Such intermediation is required not for the lack of locally informed agents, but it is needed for the lack of local intermediary capital. In addition to that, it is necessary to have a control on the professional money lenders and even on the landlords, shopkeepers, and traders who usually and frequently acquire bank funds to offer informal credit to service the financing needs of the borrowers. Such monitoring is more essentially required in the Asian countries where formal credit totals almost three-quarters of the liabilities of the informal sectors.
• Thirdly, in the less developed countries, economies are more often than not characterized as the most uncompetitive in the money market. The formal sector banks, in particular, have more market power and support typically as compared with the informal lenders.

A detailed theoretical study is required to understand this typical framework in the money market. Whether it is for the developed, developing or the underdeveloped countries, you must know about it before you visit sites such as https://www.libertylending.com/ and others to look for loan options of your choice and affordability.

Access to credit by the poor

The above framework has a few specific consequences. It reveals that the access to credit by the poor credit is affected significantly by the informal finance. According to the model, all formal banks are retrained due to the inability of the borrower to commit to using the funds provided for productive purposes.

The problem is even more acute for the poor. This is because the benefit of loan diversion increases the size of the loan. These rationed borrowers to the bank but the informal lenders can monitor and take advantage of such bank-rationed borrowers who do not have easy access or even the necessary resources to turn towards the formal sector for surplus funds.

This is once again affected in two specific ways:

• The first sets of findings reveal how informal credit helps in improving the relationship of the borrowers with the banks. The informal loans usually increase the reoccurrence of productive activities because these cannot be diverted. This, in turn, lowers the relative gain due to misuse of formal funds. It also allows the banks to provide more credit to borrowers. In short, it is the informal finance that complements the banks by letting them offer larger formal loans to the poor borrowers.
• The second set of findings relate to the informal lenders and their monitoring ability. This also helps banks the indirectly to reduce the agency cost by allowing them to channelize all formal credit through this informal sector. That means, when a lending is made directly to the poor people, the banks usually share a part of the surplus with the borrowers. This, in turn, allows them to keep them from diverting the loans. Extending such credit through the informal lenders also minimizes the need of surplus that the banks require to share as the informal lenders are rich enough to have an adequate stake in the outcome.

As a result, it is found that the credit market is segmented because the informal finance substitutes for the banks and at the same time limits the access of the poor borrowers to the banks directly.

The bargaining power

However, the extent to which this access is limited and how much informal finance will substitute or complement for bank credit entirely depends on the bargaining power of the banks. If the formal banks are more competitive, then the borrowers will be able to obtain their desired capital from both these financial sectors. This is because poor informal lenders will access the banks for additional funds.

This means, if the formal lenders have significant market power, the informal lenders will borrow only as a source of credit. Ideally, this means that the joint return of the borrowers and informal lenders is maximized when both take bank loans. The bank market power and credit market segmentation will inevitably reduce the formal monopoly and agency costs.