Academic year 1996 – 1997















Promoter: Prof. Dr. ir. P. VAN DAMME







Thesis submitted in partial fulfillment of the requirements for the degree




Financial liberalisation and other reforms in Third World countries during the last few decades have resulted in more than disappointing formal financial development.  In contrast, the informal financial sector has invariably displayed dynamics and growth in its response to the increased demand for financial services (Aryeetey et al., 1997).  Even in a context where the aim was to displace informal with formal finance, informal finance gained respectability for several reasons.  Many informal financial institutions proved to be viable and sustainable, and reached even the poorest population segments.  In general, it displays high repayment rates and high levels of savings mobilisation, often at low transaction costs (Cuevas, 1989).


In the vast majority of developing countries inflation is accelerating, which is usually one of the results of a growing burden of foreign debt (Gonzalez-Vega, 1989). Foreign assistance can not last forever and many international lenders are becoming unwilling to lend.  Furthermore, formal institutions fail to effectively mobilise domestic resources, even though it is nowadays recognised that even the poorest are able to save and do indeed save (Adera, 1995).  And lastly, the great majority of financial programmes in developing countries have failed, or have suffered from great deficiencies and continue to do so.  Financial growth in these countries has a prominent urban bias, which is clearly reflected by the clustering of formal financial institutions in these areas (Gonzalez-Vega, 1989).  Therefore, many authors express their concern with the role of rural finance in developing countries.   


In short, developing countries are characterised by financial dualism.  There is a co-existence of formal and informal finance that appear to operate side by side.  Formal finance is transplanted from abroad and subjected to government regulation.  Hence, it becomes an institutional and organised system, urban-orientated, catering for the financial needs of the monetised, modern sector.  On the other hand, the informal system is in general unorganised and non-institutional and deals with the traditional, rural, subsistence spheres of the economy.  A substantial part of informal financial arrangements root in the traditions and culture of local communities. 


However, no clear-cut line, that divides the formal and informal sector, exists.  In fact, there are many indications of substantial amounts of funds that flow between them in both directions.  It enables formal finance to take advantage of informal finance’s lower transaction costs and thereby reaches more small and rural clients.  Informal finance can usually expand their activities if they have access to the stronger resource base of formal finance and it can safely deposit informally mobilised resources at these institutions (Germidis, 1990). 


Financial dualism has important policy implications.  According to Ghate (1990), the existence of a large informal sector has implications for the efficacy of monetary and credit policies in achieving stabilisation and liberalisation objectives.  Despite the fact that informal finance has a strong dynamism of its own, the structure and functioning of the formal sector play a remarkable role in determining the nature and extent of the informal sector.  Policies can strengthen formal finance’s competitive ability towards informal finance, stimulating the latter to improve its terms; or otherwise promote linkages with all the benefits of such (Germidis, 1990). 


It has increasingly been recognised that these links are valuable and should be stimulated.  Both sectors can benefit from each other’s strengths if they are linked.  It could have a far-reaching impact on the mobilisation and allocation of resources in developing countries (Adera, 1995).


The present study investigates the possibility of linking formal and informal finance, especially regarding rural areas.  It is divided into six chapters.


Chapter one highlights developmental views on and development proceedings in rural financial markets (RFMs) of Third World countries since after the Second World War up to the 1990s.


Chapter two focuses on small farmers as a target group for informal finance.  It reveals something about their living world and constraints, especially regarding their relation to risk and finance.  The saving potential of these people and their demand for consumption credit are of special importance.


In chapter three, the attention shifts to several decisive aspects that concern RFMs and their efficiency.  Here, information asymmetry, fungibility, transaction costs regarding rural areas, and fragmentation and dualism need to be accentuated.  We try to find an answer to the question what a successful RFM look like.


In the fourth chapter formal finance is discussed, with special attention for the two major formal financial institutions found in developing countries: development banks and commercial banks.  Their major shortcomings as well as the strengths of formal finance are summarised.    


Informal finance is the topic of chapter five.  Several informal arrangements are presented, whereafter the general strengths, but also the limitations of informal finance are listed.  The second part of this chapter deals with semi-formal financial institutions.  Co-operatives and NGOs receive a closer look.


Chapter six contains the main emphasises of this study.  Is formal and informal finance complementary or competitive?  Different suggestions, experiences and strategies, which are associated with a linked system, are discussed.  They are sorted under themes like: strengthening existing linkages; tying loans with deposits; using groups to provide financial services; using informal as well as semi-formal financial institutions as intermediaries; and loan guarantees.  The chapter ends with several considerations regarding the different parties involved in such an approach.






1.1 After the Second World War Until the 1960s


Immediately after the Second World War, the ability of people in least developed countries (LDCs) to accumulate savings was considered to be extremely limited.  Especially small farmers and rural people in general were seen as subjected to a lack of employment opportunities and unable to generate surpluses to locate to market-orientated investments and other productive activities.  In short, they were generally seen as too poor to engage in meaningful production, and any form of capital accumulation seemed to be out of their reach (Coetzee, 1992).


However, western history proved that investment is a major prerequisite for growth, and investment requires capital availability.  Thus, large-scale transfer of capital to developing countries seemed to be the only solution that could be used by international development aid. These took the form of grants, which were targeted to large-scale industry, and import of agricultural technologies and infrastructure that seemed to be the most urgent or promising investments. Both capital and technologies mainly came from the industrialised countries.  Small farm and complementary off-farm activities were rarely promoted or supported.  It was expected that small farmers would see medium- and large-scale modern agricultural enterprises as an example and that they would then adopt the new techniques they use (Schmidt & Kropp, 1987). 


The essence of this policy was that its benefits would reach the whole population through the so-called “trickle down” effect (Schmidt & Zeitinger, 1995).  During the 1950 and 1960s, development economics were also strongly influenced by Lewis’ two sector model, first published in 1954.  In this model the subsistence sector (mainly agriculture) is seen as an ”unlimited” source of labour for the 'capitalist' enterprises.  Moreover, during the same period Clark (1940) and Kuznets (1966) formulated their view on the declining role of agriculture in economies over time with development (Staatz & Eicher, 1990). 


In the 1960s, financial markets in general were essentially seen as tools to tap funds for government use by bureaucrats, or to use to direct credit to a few selected sectors.  Industry was considered as the sector with the highest priority (Coetzee, 1992).  Loans with low interest rates and long maturities (i.e. periods due for repayment) granted by developed to recipient countries were supposed to create incentives for both public-and private-sector entities to initiate investments (Schmidt & Zeitinger, 1995).


1.2 The End of the 1960s and the 1970s


By the end of the 1960s, it was clearly realised that the hoped-for process of industrialisation and the subsequent “trickle down” effect had failed.  Instead, industrialisation even aggravated the existing social and economic inequalities and led to widespread poverty, rather than socially balanced growth (Staatz & Eicher, 1990).  In fact, it became clear that industrialisation policies of many countries had in effect been used to finance urban development.  Urban areas were favoured through government policies directed to economic development, which were usually very short-sighted.  They included the setting of price ceilings for food products below free market prices and overvaluation of national currency, which favour (industrial) imports and hinder (agricultural) exports of primary products.  There was also the installation of marketing boards and similar compulsory government-steered schemes for export crops by which the gains from exports were mainly channelled to governments, rather than the producers.  On top of it all, these economies were soon paralysed by inflation (Schmidt & Kropp, 1987).  


These policies and processes had numerous negative side-effects.  For example, there was a great migration from rural to urban areas (Schmidt & Kropp, 1987).  The income gap between rich and poor was frequently seen to widen (Staatz & Eicher, 1990).  At the same time financial institutions that had been created to channel external funds to target groups, e.g. small farmers, regularly collapsed under the weight of their accumulated loan losses (Schmidt & Zeitinger, 1995) (for more details, see Appendix III).


A lot of theories and arguments were developed to try to explain what precisely went wrong. The notion of “trickle down” was a major point of critique.  At the beginning of the 1970s, the expectation that the principle of “trickle down” will occur was, so to speak, officially abandoned.  It became apparent that if agriculture were to play a more important role in development programmes, policy makers would need a more detailed understanding of rural economies than that of the simple two-sector models of the 1950s and early 1960s.  The late 1960s and early 1970s were thus characterised by an expansion of research on micro-level phenomenon.  Through this, the complexity of many Third World farming and marketing systems became apparent.  Thus, the development programmes of the 1970s mainly focused on integrated development and basic needs (Staatz & Eicher, 1990). 


To mitigate the effect of urban migration, a re-channelling of capital into rural areas occurred (Schmidt & Kropp, 1987).  Development policies were now directly geared to poverty alleviation and “the poor” became a target group as direct recipients of the necessary support, int. al. as loans on favourable terms.  Socially committed institutions, e.g. NGOs (non-governmental organisations) which were close to low-income target groups, became the alternative for existing commercial and development banks, which mainly focussed on loans for large enterprises.  Still, these new institutions were seen as distributors of credit, but nobody seemed to be concerned with the capability of these institutions to survive.  The criterion used to determine their success was rather their ability to reach target groups among poor populations and to involve them in credit programmes (Schmidt & Zeitinger, 1995).


It was also during this period that women’s access to credit drew remarkable attention.  Development agencies started to focus on demonstrating the legitimacy of women’s economic activities and of microenterprise as a productive area (Women’s World Bank, 1994). 


Still, a central policy theme remained up to this stage: the notion that a massive infusion of external capital was needed to overcome Third World problems.  It was based on the following assumptions (Schmidt & Kropp, 1987):


·       farmers are too poor to save and thus investment is out of their reach;

·       cheap and subsidised credit is the only key to innovation and development in agriculture;

·       informal lenders are exploitative, while formal financial services do not exist or else their credit provision is insufficient;

·       thus, rural regions have an acute capital shortage;

·       the presence of a credit supply will stimulate overall demand for products and services and induce investment.  State intervention is the appropriate means to do this.


Agricultural loans granted in these times - be it for large enterprises, or be it for small subsistence enterprises - were only to be used for productive purposes in the strict sense of agricultural production stimulation.  Representatives of those who granted these loans supervised if loans were appropriate used.  It often went hand in hand with agro-technical assistance, the provision of other inputs like fertiliser and seed, as well as marketing assistance.  National governments and foreign donors defined detailed specifications on the characteristics that the target group should have, regardless of their creditworthiness.  They also specified the conditions for extending credit.  There was, however, little concern about important financial market factors, e.g. transaction costs and the risk incurred by financial intermediaries.  In addition, they defined the productive inputs that could be financed, regardless of their actual availability and efficiency in the local setting.  These loans were targeted at whole agricultural sectors or areas, e.g. as programmes for a specific crop.  In most cases, a routine credit appraisal of clients was not part of the packet.  Thus, financial institutions were limited to the granting of credit, exclusively for agricultural activities.  There was no question about the provision of comprehensive banking services in response to potential clients’ demand.  Also, other rural businesses that did not form part of the target group were often excluded from financial assistance (Schmidt & Kropp, 1987).


The outcome of these development strategies, also called the traditional approach, was disappointing.  Total agricultural output increased only marginally and in some cases the income of rural poor even decreased.  Many agricultural development banks became technical insolvent or otherwise dependent on a continuous flow of assistance money from their governments and/or foreign donors (Schmidt & Kropp, 1987). 


To summarise, this uni-directional stream of investments failed, or at least, proved not to be the right approach to enhance development. The greatest misunderstanding was rooted in the idea that intervention and huge subsidies in financial markets could overcome restrictive regulations in agricultural product markets.  Broadly spoken, planners’ perception of the actual situation was based on false assumptions regarding the economic conditions in rural, Third World areas and they had an overly narrow concept of rural finance.  Many loans, although targeted at agriculture, were often not used efficiently.  Government and/or official urban-based bank employees usually do not have the necessary knowledge and insight in agricultural production processes and the economics of rural households.  However, they prescribed and supervised loans for investments that they thought were the most profitable (Schmidt & Kropp, 1987).  Thus, official control shaped the LDCs’ financial system to the image of western institutions (Bouman & Hospes, 1994).


1.3 The 1980s


During the 1980s, many economists realised that, in their quest for a better micro-level understanding of the rural economy, sight had been lost on how agriculture relates to the broader macro-economic context.  A renewed concern about how agriculture contributes to overall economic growth flared up.  A swing from micro-economics to macro-economics occurred.  There was increased emphasis on markets, institutions and sustainability.  Macroeconomic adjustment and Structural Adjustment Programmes (SAPs), became famous concepts.  The focus shifted to economic growth, policy reform and market liberalisation (Staatz & Eicher, 1990). 


Many governments initiated major restructuring and reforms of their financial systems as part of SAPs (Aryeetey et al., 1997).  These programmes and policies were essentially intended to improve the development incentive structure, trade regime, allocation of resources, and efficiency in the use of resources to stimulate growth.  It emphasised the need to adopt financial liberalisation measures, and to enhance regulatory and supervisory functions to ensure prudence of financial institutions (Bagachwa, 1995).  Financial liberalisation measures included the removal of restrictions on interest rates, the elimination of credit ceilings, opening up the banking system to more competition (Aryeetey et al., 1994), while decentralisation by existing credit institutions was propagandised (Spio, 1994). 


As a result, several development-oriented financial institutions, which had an unsatisfactory performance, were closed.  This created a vacuum in which NGOs established themselves as financial intermediaries with considerable funding from major development agencies.  At the end of the 1980s, it was clear that these organisations started to play an important role in development finance (Schmidt & Zeitinger, 1995). 


According to Aryeetey et al. (1997), financial reform through SAPs had limited developmental effects.  The limitation to liberalisation policies has been insufficient to stimulate a strong response in terms of wider access to, and use of financial services, and failed to enhance savings' mobilisation, financial intermediation, and increased investment by the private sector.  Financial fragmentation, which impedes efficient resource mobilisation and financial intermediation, showed limited improvement. 


Boehmer (1995) also reports that while financial liberalisation measures positively affected incentives to lend, other measures taken to stabilise the economy and strengthen the banking system had a short-run negative impact on credit availability to small enterprises. Tight monetary policies resulted in higher interest rates on government paper than on loans to long-standing commercial clients, leading in turn to non-competitive higher rates to new, smaller borrowers. Efforts to improve portfolio performance led banks to centralise decision-making and maintain their insistence on rigid collateral requirements, a stumbling block for many small entrepreneurs (Aryeetey et al., 1994).


At the same time, most microenterprise development practitioners realised from experience that the poor, especially women, do indeed save and often repay their loans on schedule.  Nevertheless, most traditional development banks were not interested to provide financial services to these groups. The lack of interest of most banks in developing smaller enterprises as clients, particularly in the face of high yields available to banks, shows that liberalisation of financial policies by itself is not sufficient to improve access of small firms to formal finance (Aryeetey et al., 1994). The need of a greater incorporation of institutional and cultural variables into analyses of the development process was also realised (Staatz & Eicher, 1990).


1.4 The 1990s


According to Staatz & Eicher (1990)’s “Lessons and Insights for the 1990s”, the success of macro-economic and agricultural policies depends, among others, on a political environment conducive to mobilise the energy and capability of the majority of rural people.  They stress that one of the clearest lessons of the past four decades is that agricultural and rural development requires strong local institutions and well-trained individuals. 


Despite of all the SAPs, that have been initiated in LDCs, there is still room for substantial improvement in macroeconomic policies in developing countries.  However, improving macroeconomic policies is only part of the larger development effort of building institutions, creating infrastructure, and putting in place the social policies needed for broad-based growth and poverty alleviation (FAO, 1994).


The new approach concentrates on deposits, the viability of financial institutions and the sustainability of rural financial markets.  It is believed that this approach is more balanced and that it acknowledges the existence of informal financial markets (Coetzee, 1995).


A closer look to current policies of leading financial development organisations (ABOS, 1995; Bilance, 1995; and NOVIB, 1995) confirms these findings.  Building permanent financial institutions, and not temporary micro-lending projects, is a central point of departure.  The new emphasises has spawned a debate on the definitions of subsidy, self-sufficiency, financial viability and financial sustainability.


The viability of financial institutions and their services are closely related to the extent to which they respond to clients’ needs and the efficiency of their operations (Women’s World Bank, 1994).  Coetzee (1995) also points out that successful credit delivery and satisfying repayment rates depend on several sound financial principles such as understanding the needs of clients, increasing efficiency by cutting administration costs and to adapt the structure of services to local circumstances. 


Nevertheless, credit has been over-emphasised in the past.  It must be seen as a developmental strategy, which has its limits.  If credit is excessively stressed, all practices and operational procedures tend to be designed to promote the interest of the borrower, while the interest of the lender and of the institution are being neglected.  Savings mobilisation has to play a central role in financial institution development (Spio, 1994).


Nowadays, the role of financial subsidies is rather seen as an element to get programmes started, or to improve the structure of existing programmes, rather than to provide cheap loans to individuals (Women’s World Bank, 1994).


Aryeetey et al. (1997) report that, unlike the 1980s, the 1990s have been marked by increased support for the informal finance sector, because their operations perform remarkably well, despite many attempts in the last few decades to replace it by formal financial services.  Many informal financial institutions possess several of the recent desired characteristics such as sustainability, high repayment performance, high savings mobilisation, substantial outreach to lower income segments of the population, etc. (Aryeetey et al., 1997).  However, according to Aryeetey et al. (1997), reforms so far have not provided incentives for formal institutions to link more closely with informal/semi-formal agents.  In fact, although the negative consequences of the traditional approach are clearly evident, it is still followed to a large extent in many countries (Schmidt & Kropp, 1987). 




2.1 Introduction


There is a general understanding that rural areas suffer most from poverty (see Appendix VII.1 and VII.3).  A highly unequal income distribution, a most undeveloped infrastructure (both social and economic), and low human development indices accompany this opinion.  Only 30 % of Africa’s population is urbanised (Appendix VII.2) and therefore the rural population of Third World countries could be estimated at 70 % of the total population (World Bank, 1996). 


Farmers all over the world dealing with costs, returns and risks, can be considered as calculating economic agents.  Small farmers, however, are often described as poor people that operate on smallholdings. However, just like all other farmers, are entrepreneurs in their own small domain in which they subtly adapt to economic conditions.  Yet, many experts fail to recognise how rational and efficient they really are (Schultz, 1990), basically because of a lack of proper data.


Measuring rural parameters, for example, household incomes, often creates problems. Rural income is seldom recorded and usually fluctuates from month to month.  Rural households usually have multiple income sources.  Apart from diverse farm activities, they might also earn income through other, non-farm activities (Koch & Soetjipto, 1993).  Temu & Hill (1994) found during a survey in Tanzania that non-farm income contributed less significantly to the income of farmers in higher income groups. Another example is agricultural production output.  Many small farmers rarely measure their output in terms of quantity and quality.  Rural household parameters are most often based on rough estimations (Koch & Soetjipto, 1993).


Small farmers are usually illiterate and tradition-bound.  These families usually deal with costly traditional functions, such as funerals, marriages and other religious ceremonies (Hartman, 1985).  From their context, they are efficient and rational in relation to their environment.  This is part of the factor-quality hypothesis where rural stagnation is ascribed to low-quality production factors (Thomas & Tyobeka, 1995). 


Available resources and the tradition-bound objectives of the farm enterprise prevent the small farmer from reallocating production factors to improve his current output.  Schultz (1990) argues that the solution lies in investing in human capital (training) and in improving the farmers' access to agricultural inputs and technology. 


2.2 The Small-farmer and Risk


The institutional-uncertainty hypothesis, as defined by Thomas & Tyobeka (1995), adds another few elements to this analysis by stating that central to farmers' decisions to try new (more risky) practices are their expectations concerning the economic environment.  Institutional uncertainty appears in questions and apprehensions like: will production services be of satisfactory quality and delivered in time?  To what extent will I control the functioning of the delivery system?  How will my farming be affected if changes take place in the political and policy environment?  How much influence will I have over them?  Thus, institutional uncertainty leads to a climate in which otherwise motivated farmers are not eager to invest in and/or adopt more productive practices, because of uncertainty of possible gains (Thomas & Tyobeka, 1995).


In reaction to this uncertainty, farmers tend to narrow their practices and investment options to those that have proven to withstand bad circumstances.  By doing this, they try to minimise the cost of failure (Thomas & Tyobeka, 1995).  Therefore, households will take-up low-risk activities, even if they imply lower returns (Dercon, 1996).  Profit maximisation becomes a higher-order goal, which is only achievable, once lower-order goals have been obtained.  In short, the aim is to select safe-enough outcomes.  Subsistence and security are first priorities (Thomas & Tyobeka, 1995).


One has to keep in mind that the agriculture business in LDC deal with a considerable variety and extent of risks.  Not only are the natural and weather-related risks usually remarkable high, but there is often also an underdeveloped infrastructure, such as a lack of transportation or electricity, which increases risks for rural borrowers (Schmidt & Kropp, 1987).


Risks of borrowers are in fact also risks of their lenders.  Usually, financial institutions “defend” themselves against the investment risks of their borrowers through applying the banking’s “normal” forms of credit securities, e.g. in the form of collateral.  However, rural borrowers seldom possess such forms of security (Schmidt & Kropp, 1987).


According to Dercon (1996), the strategies that rural households use to offset adverse effects of income shortfalls can be divided into two types: (a) risk-management strategies, and (b) risk-coping strategies.


Risk-management strategies aim to reduce income risk.  Farmers will thus alter their farming system techniques, e.g. by building ridges and furrows for water conservation, in order to reduce production risks.  Otherwise, households diversify their income sources (although not all income diversification measures are practised together to reduce risk) and skew risk distribution by concentrating on low-risk income sources.  The effectiveness of such a strategy is related to the covariance between the different income sources.  For example, if a household diversify its total income between livestock and crop production activities, total income is still very vulnerable to drought, although less vulnerable to livestock diseases.  If selling of handcrafts is also a source of income, this household will still have some income in the case of a severe drought.  Risk-management strategies cannot be viewed independently from the strategies to cope with risks.


Risk-coping strategies aim to cushion the effects of income risk on consumption, temporary through savings and across households through mutual support networks as a risk-sharing mechanism.  The way in which households respond to income risks, depends on the options available to smoothen their consumption.  In semi-arid India, it has been found that there is a positive correlation between wealth of a household and the risk of the activity package to which the productive assets are allocated.  In addition, liquidity constraints affected the degree of diversification and the adoption of risky activities.


It is clear that it is wealthier households that end up with higher average returns, which makes further accumulation possible.  Thus, risk affects rural growth and increases rural inequality via a ‘poverty trap’ in which the poorest get caught.  Campaigns to promote the cultivation of e.g. drought-resistant crops in a certain area will on themselves fail to cut through this trap.  There will be a higher supply on the local market, which will lower the returns to the farmer and therefore will actually encourage the development of new poverty traps!  An alternative, among others, could be the creation and promotion of appropriate liquid assets for the poorer households by encouraging savings in good years which result in relative high returns and could be easily turned into money (liquidated) (Dercon, 1996).  Otherwise, the availability of credit possibilities may help to overcome this problem (Heidhues, 1992).  Such mechanisms may both supply a safety net for bad years and, in the case of savings, enhance unfolding of a higher asset base for poorer households (Dercon, 1996).


Hartman (1985) argues that farmers also avoid taking risks for fear of experiencing adverse community opinion in case of failure.  It has discouraged many farmers from investing in innovative production techniques.


2.3 The Small-Farmer and Finance


Farmers differ in their ability to perceive, interpret and take appropriate action in response to new information and situations.  Nevertheless, they all represent the essential human resource of entrepreneurship.  Agriculture is in general a highly decentralised sector of economy (Schultz, 1990). 


Allocative ability is daily display by numerous men and women on small-scale production units.  The importance of the allocation role and insight of farmers and farm women should not be underestimated.  Thus, their economic opportunities matter, they are no less concerned about improving their lot and that of their children than rich people are (Schultz, 1990).


According to Dercon (1996) there are three perspectives that justify the promotion of sustainable financial services’ systems for poor people. 


a)  Financial service development - People that are excluded from formal financial services due to gender, ethnic identity, low incomes, remoteness or poor infrastructure often have promising potential as markets for institutions that can thus reduce the costs and risks of serving them.


b)  Enterprise formation and growth - The stable availability of funds and deposit services support successful initiation and sustainability of micro and small enterprises.


c)  Poverty reduction - The poor can smoothen their consumption over periods of cyclical and unforeseen crises if they have access to stable, monatised savings facilities, thus enhancing their economic security.  Dercon (1996) argues that if economic security is reached to some extent, access to credit will help them to overcome their poverty through production improvement of their enterprises, or through the creation of new income sources.


However, it is often found that small farmers and other low-income households in LDCs are reluctant to use formal financial services.  Boehmer (1995) finds that the most prominent factors contributing to the low level of financial intermediation are:

·         low confidence in the formal financial system;

·         macroeconomic instability; and

·         lack of competition among financial institutions.


For formal institutional institutions to be accepted by the rural population – as with all clients -, they must provide services that are appropriate to the needs of potential borrowers, easily accessible and inexpensive (Schmidt & Kropp, 1987). 


2.3.1 The Small-Farmer and Credit Credit Demand


Credit demand from small farmers can be divided into three categories: (1) production credit; (2) consumption credit; and (3) insurance. Production Credit


Granting production credit is based on the believe that productive investments will enhance the production capacity of the borrower.  The typical business and investment loan does not serve the adjustment of income flows to planned expenditure, but rather the creation of additional income.  It is believed that increased income will generate the ability to create (1) the basis for servicing loans plus interest; and (2) additional profit, which will raise the borrowers’ living standard (Schmidt & Kropp, 1987).  Productive investment is indeed the precondition for sustained credit (Abugre, 1994).  This point of view has been the centre theme of the majority of financial market development literature and research. 


Heidhues (1992) states that the three dominant development objectives are (1) promoting economic growth; (2) improving distribution; and (3) strengthening institutions.  Yet, when measured by these three objectives, this approach has failed in many countries.  Agricultural production did not expand as much as was hoped for and credits were not repaid.  In addition, not all farmers or potential clients were reached and institutions providing such credit became increasingly weak.  Some even collapsed under the burden of credit defaults.  It seems as if there is an inverse relation between (i) the failure of production credit and the faltering of formal rural finance, and (ii) the income level of a country.  The explanation lies in the fact that the poorer countries are not able to subsidise loss-making financial institutions for any extended period. 


It was, therefore, also found that formal rural banks failed, particular in the poorest of Sub-Saharan countries.  It might also indicate that rural populations have a significant demand for a wider range of services, namely consumption credit and insurance, especially in poor countries.  By ignoring these demands and only focusing on production credit, however, financial institutions will fail to build a broader-based clientele in rural areas (Heidhues, 1992). Consumption Credit


The productivity of a household economy does not solely depend on conventional production inputs and income-generating activities.  Skills, education and the nutritional status of the family labour force also play a crucial role (Zeller et al., 1994).  A farm household is a complex interlinked system of production and household activities characterised by common use of labour, land and capital (Heidhues, 1992). 


There is no strict division between consumption (in the household) and investment (in the enterprise) applications in rural households.  Consumption activities are usually inseparably linked with the production sphere and vice versa, and can thus hardly be measured separately.  Labour is their most important production factor after land. Therefore, expenditures for food, health and education are all needed to maintain production. The question therefore is to know whether the maintenance of labour potential and health is a form of consumption or whether it should be considered as a long-term investment in human capital (Schmidt & Kropp, 1987)?  Another example: if a farmer borrows what is necessary to make up for a temporary shortfall in food availability, an animal will be saved which would otherwise have been slaughtered.  Such an animal is then still available to produce young, milk, blood, etc. and to provide plough power, etc., which all are of economic value.  This further relates to the insurance mechanism (Abugre, 1994).  Furthermore, social activities may serve to build a mutual support system (Heidhues, 1992). 


Thus, consumption credit is an important component of rural households' financial needs.  Schmidt & Kropp (1987) describe consumption loans as loans that permit consumption to be realised before income is actually earned and, like saving, are also a means of adjusting income flows to planned expenditure.


Rural financial markets' roles in consumption stabilisation can be divided into two possible strategies: (1) the savings/dissavings process; and (2) consumption credit.  Both are connected.  For instance, households, which are subjected to food shortfalls, can choose from various strategies to deal with this problem.  In a case of temporary food insecurity, i.e. a short-term shortfall of food availability and thus consumption below the needed level, households may diversify their income sources, sell assets or ask for support by others.  However, they may also knock on the door of informal or formal financial markets.  The closer a household is, even in a “normal situation”, to inadequate food consumption level, the greater the need for access to any of the food securing strategies.  Thus, the more income diversification, asset sale and interhousehold support strategies become limited, the more important will access to financial markets be (Heidhues, 1992).


In many cases, transitory food insecurity occurs frequently, which weaken income and productive basis development more and more.  At the end, these households are faced with a chronic food shortage.  Such a chronic food security problem can be prevented by a timely access to credit and savings markets (Heidhues, 1992).  Therefore, credit use for consumption plays a more important role in poorer households than in more affluent household (Zeller et al., 1994). 



An investigation was done in Gambia to determine for what purposes credit had been used by households.  Interesting to know is that the investigation was conducted in 1987, when agricultural production was above average.  Still, the share of credit used for food and other consumption items ranks highest in the bottom half of the different income groups.


Table 2.1.  Use of credit in The Gambia, differentiated by income groups (Zeller et al., 1994)



Income groups

  Loan Use (%)






Agricultural inputs












Other items (clothes, etc.)














According to Heidhues (1992), the interlinked phenomena in rural households have been well covered in research and documents on farming systems, and literature and development projects take this increasingly into account in their approach. 


This can not be said for rural financial market literature and even less for the project approaches in these areas.  The concept of “agricultural credit” project still dominates over “rural financial market” development.  If financial services do not provide for all needs of their rural clients, financial market development will be impeded.  Ignoring these facts will lead to approaches and programmes that bypass important needs of the rural population, especially in stress situations.  The end result will be an alienation from financial programmes of a big part of the rural clientele, particularly women and poor (Heidhues, 1992).


Abugre (1994) argues that in the case of consumption credit, amounts granted must be small on average.  Consumption credit usually does not result in immediate income improvement, and can, therefore, easily turn into a debt burden.   By granting them with the minimum of procedures, they can be inexpensive.  Community and informal groups can be used to manage the system, thus, bureaucratic structures are unnecessary.  Social norms and peer pressure within these groups will ensure repayment.  It can even be blended with the family savings, augmenting it in the process. 


(A simple household model explaining the demand for consumption credit is presented in Appendix II.)

Temu & Hill (1994) did a survey in Tanzania on financial constraints experienced by coffee farmers in 1990 and 1991. The results presented in table 2.2 makes it clear that on average, children's education caused the greatest financial constraints, followed by – in descending order – health, food, house building and lastly agricultural production inputs.  This ranking stands in sharp contrast with lending programmes by formal institutions that usually emphasise production credit. 


Table 2.2  Financial constraints experienced by coffee farmers in Tanzania  (Temu & Hill, 1994)


Farmer Income Group

Number enquired

Children's education




Agric. Inputs


























































8(9.9%) Insurance


Production and consumption credit has as immediate goal to influence income or consumption directly in a particular period.  Insurance, on the other hand, aims to increase the range of options a household has at its disposal to cope with periods of income or consumption stress (Heidhues, 1992).  It enables households to make intertemporal adjustments of disposable income, by improving their ability to adjust their consumption and investment options between periods of income and food access and shortage (Zeller et al., 1994).  In other words, insurance wants to improve a household's ability to cope with potential risk situations (Heidhues, 1992).


Besides the fact that the sources of risk in rural households are manifold, their timing, intensity and income impact are difficult to anticipate.  Many rural households have seldom access to insurance schemes.  Even against common hazards, insurance is scarce (Baker & Bhargava, 1983).  Formal insurance markets and social security systems are often non-existent or, at least, non-accessible for the poor (Zeller et al., 1994).  In fact, formal forms of insurance are merely one element of the financial security system.  The financial security system in rural areas are most often dominated by traditional self-insurance (Temu & Hill, 1994). 


There is a range of informal strategies that are used.  Third World habitants may protect themselves by saving in the form of cash, deposits, food, livestock, jewellery or other physical assets (Temu & Hill, 1994).  For instance, grain storage is a form of protection against increases in the price of the basic staple food and, at the same time, a source of seed for the next planting season (Heidhues, 1992). 


Some people believe in building insurance networks of social relationships, by establishing an image as reliable and creditworthy in the village, the family, with the neighbours or with local money-lenders and other potential credit providers (Schmidt & Kropp, 1987).  Others diversify their production structure, cropping pattern and income source, by off-farm activities.  Still, these self-insurance mechanisms may not be enough, especially in situations of extended or co-variate risk, i.e. where the whole community is simultaneously affected by an emergency, e.g. climatic catastrophe, or unexpected price shocks (Heidhues, 1992; Zeller et al., 1994).


Self-insurance strategies of poorer households tend to have negative side effects.  Their low-risk resistance makes them cling to production practices and crop diversification patterns that they known well.  Thus, the adoption of new technologies is hampered and economies of specialisation and technology transfer are thereby foregone (Zeller et al., 1994). 


However, populations with a lack of access to appropriate formal finance and insurance schemes will turn to indigenous informal savings and credit arrangements, despite of all their shortfalls (Heidhues, 1992).


The mere access to credit, not actually borrowing, can serve as an important insurance substitute.  Potential access to borrowing will enable a household to transfer a part of its risk to the financial market (Heidhues, 1992).  It gives them a feeling of consolation by knowing that there is a way out if things go wrong.  Therefore they might be more willing to take riskier steps than without this insurance.  Abugre (1994) also argues that credit availability to the poor in flexible forms may be the most secure insurance against emergencies.


2.3.2 The Small Farmer and Savings


(Appendix II gives a broad discussion on savings mobilisation.)


Contrary to the believe that rural people have no margin to save, it is widely documented that they do indeed save (Adams & Canavesi, 1989; Adams & Graham, 1980; Coetzee, 1992; Mauri, 1983; Miracle, 1980; Schmidt & Kropp, 1987; Spio, 1994; Von Pischke, 1983). 


In fact, they have to save!  Liquid reserves are necessary to meet emergencies, which frequently occur in subsistence farming.  The agricultural production cycle requires accumulation of surplus to rely on during non-productive periods.  Thus, these people are forced to abstain from immediate consumption of their produce because there is an absolute need for savings, at least on a temporary basis (Mrak, 1989). 


Rural savings occur through formal or informal intermediaries, or otherwise through hoarding (Mrak, 1989). 


Adams & Canavesi (1989) state that the primary motivation for most people who want to participate in a financial system is to save, and not to borrow.  This is in sharp contrast to the basic assumption behind many governmental and donor sponsored financial projects that stare blindly at credit provision.  According to Adams & Vogel (1990), the volume of funds that can be obtained through effective saving mobilisation and loan recovery programmes, is potentially far greater than most estimated amounts of subsidised loans and grants available from governments and donors.  There is enough evidence that substantial amounts of savings can be mobilised in the rural areas of LDCs (Adera, 1995; Miracle et al., 1980; Von Pischke, 1996).


After years of only supporting subsidised credit programs, the government of Korea implemented two related endeavours in the mid-1960s: (1) increased interest rates and (2) a national drive to promote rural saving through rural co-operatives.  The results were dramatic.  Savings increased from 12 percent of household income in 1963 to 33 percent in 1974.  Even the smallest farms and households were motivated to deposit significant amounts of money, by an increased rate of interest paid on deposits and the ability of rural co-operatives to provide a secure, convenient, and inexpensive way to save.  The perception of co-operatives as secure places to hold savings was enhanced by the increased and more dependable supply of lending funds provided by savings mobilisation.  A dense network of rural co-operatives meant that rural savers did not have to walk long distances and costs of transportation were cut, thereby making banking inexpensive and convenient (Lee et al., 1983).


Any effort to mobilise savings should begin by emphasising incentives for voluntary savings.  The client must see the deposit facility as a valuable service and not as an imposition or a mere tool to increase the effective cost of credit.  Forced savings will lead to aversion at the clients’ level and let him loose interest in his accounts.  To prevent this, high quality banking services should be provided to depositors (Spio, 1994). 


The core factor in a voluntary savings mobilisation programme is to create attractiveness through a reward paid on savings along with the convenience, liquidity and security of savings (Yaron, 1994).  Therefore, savings financial institutions should adapt appropriate financial technology which includes attractive rates of interest as well as conveniently located banking facilities and offices, so that farmers have quick access to them.  It is also recommended to link saving deposits with other services, both financial and non-financial, e.g. credit with purchase of surplus farmers' produce.  Services should be based on a sufficiently low cost basis (Mrak, 1989). 


Furthermore, according to Dercon (1996), savings, i.e. the amount of liquid assets that are available as a buffer, affect the amount of risk a household is willing to take.  Improved savings mobilisation may support other development activities in the sense that farmers are less hesitant to try unknown innovations, which they would normally perceive as risky. National Accounts and Forms of Saving


According to Mauri (1983), the contribution of subsiste­nce economy to the GNP is very often underestimated.  Moreover, the savings threshold (i.e. the minimum income above which savings can occur) is much lower in Third World than in First World countries and also lower in rural than in urban areas.  Especially in rural areas of LDCs, a substantial part of the household's disposable income is kept aside from consumption.


Nevertheless, Mrak (1989) points out that savings potential in rural areas is underestimated.  There is a discrepancy between real household’s saving and savings accounted for in the country’s national accounts, especially regarding rural areas.  Reasons to explain this could be divided into two broad categories:


1.       non-monetary (i.e. physical goods) forms, where savings occur in a non-mobilised way through non-monetised investments, including livestock, jewellery, precious metals, construction materials, etc.  Agricultural products surpluses are kept as a safety precaution for a possible bad crop the following year.  Traditionally, cattle have been an important non-monetary form of peasants’ savings in many African cultures.  It can be referred to as "the classic symbol of the African's social standing" (Temu & Hill, 1994).  Cattle are often used as a measure of value.  In fact, in cases where there exists a high inflation rate and little market integration there is little or no incentive to keep assets is the form of money.  Boehmer (1995) argues that, conservatively estimated, if 16 percent of existing non-financial savings in Ghana were brought into the financial system, the increase in real GDP growth would be in the order of 1 percentage point.  With a faster uptake, even larger gains could be achieved. 


2.       a considerable part of monetary savings stays out of reach of formal financial institutions (Mrak, 1989).  In cases where the economy is already partly monetised and where cash crops have replaced subsistence crops to a certain extent, surplus money emerges.  This does not imply that savings’ mobilisation will occur, since money itself can also be hoarded (Mauri, 1983).  For example, in Zambia many people in rural areas bury their cash or hide it in one way or the other where it does not appear in the ordinary, visible economy of the country.  It surfaces in times of special needs, such as dowries, settlement of litigation cases or family emergency (Mrak, 1989).


The extent of hoarding, no matter in what way, is an indication of the gap that exists between what is productively invested and what could be invested without substantially changing consumption patterns (Mauri, 1983).  In general, savings in rural Africa are not clearly distinguishable from investment or consumption, especially where livestock or consumer durables are involved.  The relevant point of debate is whether it is possible and advantageous to save in monetary form and by depositing at financial institutions, rather than to find an answer to the question of to save or not to save (Schmidt & Kropp, 1987). 


Traditional forms of savings are subjected to a range of risks, which include theft, pest and disease in case of livestock and crops, etc.  If money is hoarded, it is subjected to the loss of purchasing power due to inflation.  Saving in the form of jewellery is often done simply to convert personal savings in a form that is not readily accessible by other household members, relatives and friends (Zeller et al., 1994). The Small Farmer and Saving Institutions


Theoretically, it can be argued that setting up financial outlets or banking facilities in rural areas will enable savings to be properly invested, rather than that they would remain idle and sterile.  It is supposed to even stimulate farmers to save more.  However, such institutions, e.g. commercial banks, are not eager to attract small savings accounts, because they are troublesome and costly to handle (Mauri, 1983).


Nevertheless, Coetzee (1992) finds that where formal institutions are available, rural people use them intensively to keep their savings and that they are willing to pay these institutions to do so.  It has been illustrated by the popularity of postal savings and some commercial banks as deposit taking institutions.  It is only in areas where there is a risk of high inflation that people tend to save in the form of physical assets, like jewellery, livestock and implements. 


Personal savings formed in urban areas can not be expected to flow to the farming sector due to the more attractive opportunities offered in other economical sectors, e.g. industrial investments.  Local agricultural investments must mainly rely on what is saved by rural households themselves (Mauri, 1983).  Yet, if financial institutions succeed in mobilising funds from farmers, they often cause savings to flow from rural to urban areas instead of being ploughed back in rural areas (Coetzee, 1988; Mauri, 1983).  A good example of rural deposits channelled towards the public sector is postal savings.  Postbanks only offer saving services, thus no credit options exists.  Rural people are encouraged to use these institutions, because transaction costs are relative low to other formal financial institutions and these banks are prepared to handle small amounts.  A wide network of branches exists, which means that rural people do not have to travel long distances (Coetzee, 1988).  Mrak (1989) refers to a similar case: the savings bank in Zambia.  It has the broadest network of offices of all formal financial institutions all over the country and therefore has a strong potential to mobilise savings in rural areas.  However, it channels the collected funds to the government. 


Due to the limited availability of convenient formal financial institutions, many rural communities depend on informal financial arrangements to meet their high demands for financial services.  Regarding savings, examples are self-help groups like ROSCAs and ASCRAs, and informal mobile bankers like susu collectors in Ghana.  Informal systems are discussed in chapter 5.







3.1 Introduction


Financial markets can be described as a range of institutions that specialise in accepting saving deposits and granting credit and finance (Schmidt & Kropp, 1987).  Rural financial markets (RFMs) consist of relationships based on transactions between sellers and buyers of financial assets in a rural economy.  These transactions include lending, borrowing and the transfer of ownership of financial assets (Von Pischke et al., 1983).  Some also offer insurance services (Zeller et al., 1994). 


Savings reduce disposable income and consumption in the current period, but increase it for future periods.  Borrowing, on the other end, increases current disposable income at the expense of available income in future periods.  It enables investment into human and physical capital that may improve future income and consumption, or avoid shortfalls in current consumption (Zeller et al., 1994).


As for all financial markets, the ultimate function of RFMs is to increase the financial resources available to the economy and to enable a more efficient use of resources.  This indicates that financial markets facilitate financial intermediation and management in order to stimulate and accelerate the process of economic growth (Coetzee, 1992).


Besides formal institutions, RFMs also involve informal-sector intermediaries as well as private borrowing and lending that do not include intermediaries.  RFMs are an alternative for rural people to hold their liquidity reserves in savings trusts rather than hoarding.  Otherwise, unused credit potential is offered as means of synchronising their expenditures and receipts over time (Lee, 1983). 


Thus, RFMs are supposed to fulfil several important functions.  They include:


(a)    income generation/increase through production/investment credit (Heidhues, 1992).  As a result, it can improve income distribution, by making purchasing power available to those with few resources of their own.  With this they can take advantage of productive opportunities that otherwise would have been forgone (Gonzalez-Vega, 1989);


(b)    income and consumption stabilisation through savings/dissavings and consumption credit (Heidhues, 1992);


(c)    overall financial stability is also enhanced through greater market integration and opportunities for risk management (Gonzalez-Vega, 1989).  The demand for income security/insurance is fulfilled through providing potential access to financial resources (Heidhues, 1992);


(d)    increasing the productivity of available resources, which means that the efficiency of resource allocation is enhanced (Gonzalez-Vega, 1989);


(e)    increasing the flow of savings and investments, thus contributing to faster economic growth (Gonzalez-Vega, 1989).


3.2 Important Elements in Finance


3.2.1 Intermediation 


The conventional explanation of the idea of financial intermediary is usually in the sense of the activities of formal financial institutions that simultaneously mobilise resources from a certain part of the population (savers) and transform it to fulfil the need of others (borrowers) (Christensen, 1993).  In other words, financial intermediaries are third parties that activate the transfer of resources from less productive uses to activities where it can be more profitably employed (Gonzalez-Vega, 1989).  This is a critical process in order to assure efficient use of financial resources (Christensen, 1993).


It is important to keep in mind that financial intermediaries are active in imperfect markets.  The greatest constraints imposed on them by these circumstances are a lack of information, imperfect competition, factor immobility and significant externalities.  Furthermore, different intermediation institutions have different strengths and shortcomings.  Some are very awkward if it comes to small deposits and loans, others are not capable to handle the risks of financial intermediation in rural areas, while some have weaknesses as specialised lenders (Von Pischke et al., 1983).


The rural population is heterogeneous, mostly with seasonal expenditures and incomes and submitted to technological change and high risks.  This suggests a strong demand for effective financial intermediation in these areas and that even the poorest will participate in effective credit and savings mobilisation programmes.  This demand is reflected in the fact that households normally hold only relative small amounts in liquid financial savings and possess relative large amounts of goods.  To worsen this idea, these real goods are subjected to storing costs, spoilage and theft and are usually unproductive and not suitable to be mobilised to support loans (Dercon, 1996).


To overcome the many hindrances that hamper the access of large potentially productive segments of the developing world’s population to formal financial institutions, more conventional financial intermediation is needed.  More attention should be given to the building of confidence, knowledge, information and skills among these groups. This implies that the financial institutions should change their operational procedures and skill mix in order to expand their outreach.  This process of developing new markets among the working poor is referred to as social intermediation.  It must change the idea of a beneficiary to that of a client that get involved in a contract with reciprocal obligations.  The level, nature and time horizon of the investment required for social intermediation depends on the barriers that a certain group has to deal with.  It also varies according to the level of responsibility in financial intermediation that is required (or willing to be acquire) by the client group (Dercon, 1996).


Financial intermediaries need to generate sufficient surplus to be self-sustaining.  This may be hampered by governments and foreign assistance changing their priorities from time to time which causes shifts that have a profound effect on institutions supplying rural loans and other financial services (Von Pischke et al., 1983).


Government policies have a great effect on the performance of financial intermediaries.  Intermediaries come with new techniques or services to bypass regulations that adversely effect their costs and revenues.  These arrangements often tend to be anti-developmental because they increase the social costs of the intermediation process (Von Pischke et al., 1983).


It is found that most informal lenders provide valuable intermediation services that formal intermediaries fail to provide effectively.  Therefore, these informal activities will expand with the growth of economic activity in rural areas, rather than - as often expected - disappear.  However, if the development process is prolonged and sustained, structural changes may happen that make formal intermediation more attractive and accessible for rural habitants and thereby reduce the share of informal finance (Von Pischke et al., 1983) (see chapter 6 for a more in depth discussion about Informal Finance). 


3.2.2 Fungibility


The Concise Oxford Dictionary (1990) defines fungible as being “something that can serve for, or be replaced by, something else answering to the same definition”.  In other words, fungibility can be explained in the sense of the interchangeability of things that are the same or uniform (Adams & Vogel, 1990).  For example, each kilogram of grain of a specified type and grade is for all practical purposes identical to any other kilogram of grain of the same type and the same grade.  Likewise, one unit of a country's currency is identical to every other unit of this currency, and therefore, finance is fungible. One unit of money, be it owned or borrowed, is just like any other unit of money.  Fungibility underlies the usefulness of money in the sense that a lack of fungibility creates the inconvenience of barters (Von Pischke, 1996).


Any household can make three choices as a result of a loan (Adams & Vogel, 1990):


(a)    it can increase its expenditure on agricultural production by using all of the borrowed money to buy agricultural inputs.  Thus, its own money plus borrowed money is used to buy agricultural inputs;


(b)    the borrowed money alone may be applied to buy agricultural inputs.  Its own money is then used for household consumption;


(c)    all the available money can be diverted to consumption.


Loans give borrowers greater liquidity, increasing their overall purchasing power.  This might allow the household to buy some costly consumption items that it was unable to buy without the loan (Adams & Vogel, 1990). 


For all practical means, all sources of funds contribute to all uses of it.  Thus, money acquired from loans, sale of livestock and assets, savings, etc. can be used to buy loan-financed goods, home improvements, clothes, land acquisition, etc. (Von Pischke, 1996).  It makes it difficult to identify what exactly is financed by a loan.  The problem worsens when large numbers of borrowers, who are geographically dispersed, are involved (Adams & Vogel, 1990).  This is the bottomline of fungibility and the difference of finance with other inputs, tools and machinery of which the uses are restricted to specific purposes.  For example, tractors can only provide motive power (Von Pischke, 1996).


According to Von Pischke (1991), small rural borrowers in developing countries, where economic conditions are improving and markets are reasonable competitive, tend to multiply their sources of income.  Their agricultural incomes are erratic due to natural factors that have a negative impact on yields or production, and relatively low due to market conditions.  Government policies may also have an adverse effect on farmer's income (Adams & Vogel, 1990). 


In their role as resource allocators rural people have a great incentive to diversify their income, which include their loans.  It is furthered by low and uncertain returns, which is often the case.  To grant loans in kind is not a solution, because borrowers can usually sell these inputs in secondary markets.  This cash is then of course available to buy other goods or services (Adams & Vogel, 1990).  According to Aryeetey et al. (1997), even if the diversity of funds is effectively controlled, the recipients of the funds frequently represent only a small portion of the farming population and thus the distortion in resource allocation is not significantly modified.


Fungibility diffuses the impact of finance (Von Pischke, 1996) and it is hard to control.  It is virtually impossible for policy makers to allocate loans effectively in accord with a credit allocation plan, together with the fungibility factor and the numerous borrowers and lenders that participate in decentralised rural financial markets.  This is especially true where loans are targeted to specific activities (Adams & Vogel, 1990). 


The allocation of money by the farmer is not necessarily aligned with the intentions of the planner who decided on a credit scheme. For example, cheap loans may be programmed for a crop like maize to compensate for low maize prices.  Policy makers will then tend to convince financial intermediaries to extend loans for this purpose.  But low maize prices will cause the expected returns from investment also to be low.  Thus, borrowers will rather divert additional liquidity to activities where he/she will receive higher returns (Adams & Vogel, 1990).  The essence of this is that the argument that subsidised credit should compensate farmers for other policies that penalise agriculture is often not valid, because the subsidy does not alter the profitability of agricultural activities that are adversely affected.  It also implies that additional loan funds may generate only a partial or even no increase in investment (Yaron, 1992).  This is one of the most important factors that distinguish credit from other inputs.  Credit or money is not just another input!


The fungibility of money poses a serious problem for the evaluation of credit programmes (Coetzee, 1992).  In this respect,  Adams & Vogel (1990) state that fungibility is a factor in RFM project evaluations that is still poorly understood.  There are three terms that explain the difficulty of evaluation due to fungibility; “additionality, substitution and diversion”.  “Additionality” refers to the difference between the with- and the without-project situations.  Did the project add something that would otherwise not have occurred (Von Pischke & Adams, 1983)?  It is seldom possible to know what would have happened with the farmer's situation in the absence of a loan.  Thus, this also obscures the impact of a loan.  If a person had not received a specific loan, would he/she have borrowed elsewhere or perhaps cut back on specific expenditures and gone ahead with others on the same scale as if the loan had been received?  Or would he/she have scaled back all his/her activities or otherwise, have tried to accomplish his/her investment objectives gradually over an extended period of time?  On a higher level, would local credit institutions have channelled funds away from other activities to serve project objectives in the absence of the project?  In short, to what extent do project funds simply substitute for other resources that would have been use for the objectives of the project, rather than supply an additional element?  “Additionality” is difficult to measure. 


Diversion refers to the use of a loan for a means not authorised by the loan contract.  It is not only a symptom of programmes that lack proper supervision or management information systems, it happens even in well-administered programmes.  In addition, the close supervision of numerous rural clients is an expensive process.  And last, but not least, most of the relevant countries suffer under inflation, which erodes the purchasing power of their citizens.  Thus, even if the nominal amounts of loans and farmer expenditures expanded in the right direction, the real value of it may remain constant or even decline, due to inflation (Von Pischke & Adams, 1983).  Von Pischke (1996) also states that the future is unknown and the fact that credit has a time dimension makes the counterfactual or 'what if?' situation speculative and hypothetical. 


From 1960 to 1978 a total amount of $95 million was granted to the government of a Latin American country from a foreign aid agency for agricultural credit projects.  After implementation, a positive evaluation report was submitted on the project.  Loan officers and borrowers indicated that project objectives related to type of borrower, enterprise, inputs, and loan term structure were largely met.  Still, small farmers complained about a shortage of agricultural credit.  Another evaluation was done, but with other criteria for success.  Imports, the government budget, and overall financial market performance were examined.  Over the period that the project was implemented, the proportion of government funds allocated to agriculture was more or less equal to the loan.  There was no additional funding from the government.  At the same time, other sectors received increased budget allocations (in real terms) from the government, e.g. defence, non-agricultural development and general expenses.  No wonder the second evaluation revealed that the volume and loan term structure of agricultural loans stayed the same or even decreased.  This clearly demonstrates the concept of diversion of funds and fungibility at government level (Coetzee, 1992).



According to Abugre (1994), on the level of the rural farmer, quality of life indicators may be more appropriate to explain and overcome fungibility complications of credit than purely economic measures.


To conclude, fungibility implies that the use of finance does not directly correspond with the purpose for which it is obtained.  This emphasises the importance of confidence and trust in financial relationships.  It can even be said that the confidence in the borrower is just as important as the confidence in the project or loan purpose (Coetzee, 1992).


3.2.3 Information and Risk


A loan transaction is much more complicated than transactions in, for instance, product markets.  In the latter case the task and objective is simple: sell the good and the transaction is terminated upon receipt of payment.  There is no concern about who the client is or what happens to the commodity after the transaction.  As long as the seller gets his/her money, everything is all right (Llanto, 1990).


In the case of a loan transaction, the lender requires a great deal of information.  Well-run financial institutions are well informed about their clients, their clients' activities, and the markets in which their clients operate (Von Pischke, 1996).  In other words, personal characteristics of the borrower, the loan purpose, the creditworthiness of the borrower and his strategic behaviour.


In short, loan allocation has all to do with risk and risk management.  Von Pischke (1994) states that information is the most crucial ingredient in risk management.  Relevant, valid and timely information is needed in order to understand the operations of an enterprise.  The greater the amount of such data about the loan applicant and the markets in which he operates, the more refined the rational credit or investment decision will be. 


Finance is always a risky business.  Financial markets trade cash in the present time for promises of returns in the future.  The chance that the promise realises relates for a significant part to creditworthiness. To conquer this uncertainty, confidence is needed.  Yet, confidence is nothing else than an emotion, an impression or a state of mind, with the concomitant subjectivity.  To be rooted in a firm foundation, it has to be backed up by often complex and profound analyses, which brings us back to the extreme importance of information (Von Pischke, 1994). 


Moreover, it is not always easy to establish creditworthiness.  A lender has to estimate the probability of lack or failure of repayment, which gives rise to a lot of questions.  This information is accumulated through experience and a continued relationship with a particular client.  Once a good reputation has been established, the client protects it, because it is a valuable, though intangible asset.  This asset becomes more valuable if the financial programme is not a transitory project, but a permanent institution (Gonzalez-Vega, 1989).


This means that, in general, all banks spend a lot of time investigating the viability and creditworthiness of new or less known projects and borrowers.  They are concerned about what the borrower will do with the loan, how it will be used, if he will be able to stick to the terms and conditions of the contract, if he will be able to pay back, etc. (Llanto, 1990).  Another question is to know whether the profit on the investment will be high enough to repay the loan with interest and what the chances of failure in the project are (Rajasekhar, 1996).


At a reasonable cost, the lender is unable to distinguish between a potentially good and bad borrower.  'Reasonable costs’ imply costs that are still acceptable for the bank and the clients to make the transaction worthwhile.  This principle is called adverse selection (Aryeetey et al., 1997).


Borrowers, on the other hand, have far more information on their intended action and creditworthiness than the lender.  They know their own intentions better than, for instance, the bank.  They are also aware of their own industriousness and moral standards and have “inside information” about their own projects.  Furthermore, borrowers can derive potentially great benefits from understating personal and project's weaknesses and exaggerating positive qualities.  Thus, they can not be expected to fully surrender all relevant personal and project information (Llanto, 1990).  This leads to a situation called asymmetric information (Coetzee, 1992).  Still, the borrower may face a risk that the expected increase in income from an investment project for repayment may or may not materialise.


It can thus be said that the lenders' risk has two elements; one relates to the same risk that the borrower has and the other is the borrowers' commitment to pay: even if he is able to repay, he may not actually repay.  In other words, it might be a situation of wilful default.  The perception of both lender and borrower of the risk of their ventures, or in other words, their expectations to the outcome of a credit transaction, depends on whatever information and data are available to each one of them and their interpretation of them.  It is thus very subjective (Rajasekhar, 1996).


The acceptance or rejection of a loan application depends on the amount and quality of the information about the borrower and his/her project.  The chance that borrowers might disguise their true worth and character are counteracted by the lenders' preference to those with proven credit track record and acceptable collaterals, apart from the profitability and bankability of a project.  Therefore, the lender becomes also concerned about variables such as collateral, borrower's equity, cash flow, consumption patterns, other debts and other personal characteristics of the borrower.  Because of this, most lenders are forced to install elaborate screening systems for granting credit and even more for rural credit, in order to identify good borrowers, viable projects and sure income and profits (Llanto, 1990).


Asymmetric information is a serious problem in rural financial markets.  It causes a complex credit market structure and an institutional bias against small, rural borrowers that are both formidable and severe.  Loan contracting becomes even a bigger problem to borrowers who can not send the appropriate signals or indicators of bankability, which is most often the case in rural areas in developing countries.  Furthermore, the production and transfer of information is costly and make banks even more reluctant to lend (Llanto, 1990).


The economic agents of rural credit markets are very heterogeneous.  Their characteristics, attributes and personal circumstances may not be quite acceptable to banks.  Regarding the rural economic agents, the bank and its operations may be totally strange to them.  Thus, the information gap exists from both sides (Llanto, 1990).


In the end, asymmetric information hampers the borrowers' access to financial resources and the bank looses the chance to mobilise and invest the rural financial surplus.  Llanto (1990) illustrates the denial to financial resources through figure 3.1.


Cell (d) represents the situation where a serious information gap exists between the two transactors, which leads to little or no contracting.  On the other side, the two contractors may have 'perfect' or at least satisfactory information about each other and the project that is to be funded.  In this case the loan is contracted, as shown by cell (a).  When the information structure for banks and rural borrowers is inefficient or imperfect, partial contracting results as shown in cell (b) and (c).  This may include credit-rationing (Llanto, 1990). 


Information Efficiency


Rural Borrower




Information Efficiency










(a) Loan is contracted



(b) Partial loan contracting





(c) Partial loan contracting


(d) Little or no contracting



Figure 3.1 Transaction matrix in credit markets (Llanto, 1990)



Von Pischke (1996) also mentions that this situation of limited information may prevent outsiders (formal lenders) to penetrate the credit markets in villages he surveyed.  Furthermore, imperfect information can result in the persistent fragmentation of financial markets (Aryeetey et al., 1997).


Another remarkable problem that results from asymmetric information is moral hazard.  It can be defined as the actions of economic agents where they maximise their own utility to the detriment of others.  In a system of joint liability, such as in cohesive group situation, an individual member reaps all the benefits of his action, but the group bears the negative consequences (Coetzee, 1992).  It is a significant problem at group lending schemes (Huppi & Feder, 1990) (see also section 6.4.3). 


3.2.4 Transaction Costs


Financial services are not cheap.  Transaction costs have a central role in explaining trends and difficulties in finance.  In financial markets, these costs arise from the contracts between actors, or otherwise the costs of establishing and maintaining financial relationships (Von Pischke, 1996). It represents all the resources and sacrifices needed to transfer one monetary unit of currency from a saver to a borrower, and recover that unit after a certain period of time and therefor create friction in financial markets (Adams, 1991).  This transfer includes lending, borrowing and saving.  In economic terms, it can be explained in the sense of ownership transfer or the cost of running the economic system (Coetzee, 1992).


The amount of transaction costs and the way in which they are shared tell a great deal about how RFMs perform (Adams & Vogel, 1990).  According to Gonzalez-Vega (1993), the measurement of transaction costs is an important component of evaluating the effectiveness and efficiency of RFMs.


Mainstream economists until after the Second World War basically neglected all transaction costs.  In the 1960s, it was realised that market failures had transaction cost origins.  Economists, both from the neo-classical school and the new institutional school started to highlight this phenomenon, but not without disagreement.  The neo-classical school mainly sees transaction costs within the context of a market failure, while the new institutional economists sees it as an integral part of the market (Coetzee, 1992).  During the 1980s, the measuring of transaction costs resulted in different explanations of their magnitude and variations.  Still, there was a firm agreement on the fact that transaction costs have major consequences for resource allocation (Gonzalez-Vega, 1993).


Transaction costs are specific to each transaction.  They include information gathering, security arrangements to protect cash, documents and other data, recording systems for transaction processing, and decision-making.  Transaction costs determine which products are generated in financial markets, as well as who provides these products and who makes use of them (Von Pischke, 1996).  They play an important role in limiting the services that financial institutions are willing to provide in rural areas, to poor people, and to new clients (Coetzee, 1995).  That is why innovations that reduce transaction costs widen access to financial services (Von Pischke, 1996).  Coetzee (1992) also states that the higher the transaction costs, the lower the volume of transactions in a specific market.  If the transaction costs is extremely high, exchange can not take place and therefore it can be said that the market does not exist.


Transaction costs have a fixed-cost character, which implies that smaller financial transactions are more expensive when compared to larger transactions.  Therefore, a reduction in interest rates will have a greater effect on bigger loans and deposits, because transaction costs stay the same (Zeller et al., 1994).  Transaction costs are not related to the account balance or the transaction amount (Von Pischke, 1996).  Different studies indicate that in the case of small borrowers, borrowers’ transaction costs are more important than interest rates.  This is in contrast with large borrowers, who are very sensitive to interest rates, because interest make up a large part of their total borrowing costs.  For them, transaction costs are small compared to the amount deposited or borrowed, and thus often negligible (Adams & Graham, 1980).  Therefore, borrowers and depositors of small amounts are often treated with a sense of inferiority (Adams, 1992).


The key to understand intermediation and the structure of markets lies in transaction costs.  The lack of information and uncertainty as well as the enforcement of contracts (Gonzalez-Vega, 1993) stands high on the list of elements contributing to transaction costs.  Transaction cost would have been needless and measurement and enforcement unnecessary, if information were perfect and costless.  Yet, information is imperfect and costly, although in varying degrees (Coetzee, 1992).


Transaction costs are most often too high in relation to the expected return from a loan to obtain the ideal quality and quantity of information.  Thus, incomplete and restricted contracts arise.  Furthermore, the uncertainty about the future is great, the number and nature of eventualities to be considered are very large.  Therefore, it is impossible to cover the cost of anticipating them all, or to write a contract, which specifies desired actions in case that one of these eventualities becomes reality.  This is especially true when transactions are infrequent and small.  Therefore, participators of financial agreements have to settle for second best contracts.  Uncertainty and incomplete contracts lead to the situation where economic agents do not bear the full consequences or do not enjoy the full benefits of their actions (Coetzee, 1992). 


Transaction costs include non-financial costs.  All participants in the market, including depositors, borrowers and financial intermediaries, are tied to non-financial costs.  The level and distribution of these costs amongst participants in a market are influenced by changes in technology and consumer preferences, enforceability of contracts as well as the internal efficiencies of financial institutions (Coetzee, 1992).


Sustaining and expanding financial services depend for a great part on decreasing transaction costs, both for the institutions and their clients (Adams, 1991).  Coetzee (1995) argues that the reasons for high transaction costs lie in the degree of development and the maturity of the financial system, the available transport and communication facilities and the efficiency of legal systems.  Financial regulations must also be kept in mind, while subsidisation of interest rates for targeted borrowers raises the cost for non-targeted.  Many formal institutions in rural areas fail to create economics of scale, they lack information regarding their clientele, while many are not managed well and do not actively pursue cost-reducing technologies and innovations (Coetzee, 1995).  According to Spio (1994), transaction costs tend to be high when financial institutions do not depend on deposits as sources of funds.  Many state-owned institutions are victims of excessively bureaucratic procedures and attitudes.  They are often expected to serve as a source of employment, which result in costly and inefficient systems with low productivity, but also with high labour costs.  This increases the transaction costs for both institutions and clients (Coetzee, 1995). Clients' Transaction Costs


The main transaction costs for savers and loan applicants at the formal market are to gain access to them by establishing financial relationships (Adams, 1994).  Needless to say that excessive transaction costs encountered by clients of financial institutions discourage them from seeking loans and making deposits (Coetzee, 1995).


Savers are concerned about the net return on deposits, after transaction costs are subtracted from interests earned (Gonzalez-Vega, 1993).  They must win confidence in the institutions and be assured that their deposits will be accepted.  They desire to be treated respectfully.  When an account is opened, a photograph or document of their identity and residential address is most often required by formal institutions.  In many countries, these identity documents may be costly and/or difficult to obtain (Von Pischke, 1996).


Rural areas and less prosperous urban areas are often characterised by a lack of modern financial institutions or inconvenient office hours.  Aspirant depositors have to spend time and/or money, walking, cycling or riding to get to bank offices.  Moreover, these trips have their own challenges, including temptations to spend, security worries, long queues at public transport halts and stations as well as in banking offices (Von Pischke, 1996).  Other costs include bribes, legal and title fees, paperwork expenses, etc. (Adams & Graham, 1980).  All these costs often force low-income depositors to accumulate wealth in other forms, such as domestic animals (Gonzalez-Vega, 1989).


What matters for borrowers is the total cost of funds, including interest and transaction costs.  This is the case for both production and investment decisions (Gonzalez-Vega, 1993). 


Aspirant borrowers have to obtain information about the available sources for funds, the terms and additional conditions attached to them.  Credit relations also require documentation and possibly an existing deposit account relationship.  In addition, loan applications are subjected to processing delays.  Here, the time and money consumed by transport, queuing and all other effort, is also part of the deal (Von Pischke, 1996).  Clients may be forced to visit the bank many times, in order to negotiate, obtain, and repay the loan (Adams & Vogel, 1990).  Time spent in these activities has an opportunity cost.  It means lost opportunities to generate income or enjoy leisure.  Moreover, there are the risks of lawsuits and losses of collateral, if repayment fails (Gonzalez-Vega, 1989).  This results in a suppression of the attractiveness of borrowing and impedes the value estimation of it (Von Pischke, 1996).


Transaction costs of borrowing and depositing was measured in several countries, including the Philippines, Bangladesh, Honduras, Costa Rica, Niger and the Dominican Republic (Gonzalez-Vega, 1993).  The results pointed at very regressive distribution effects of borrowing costs.  It demonstrated a negative elasticity between transaction costs per unit and loan size.  Borrowing costs were basically reduced by 6-7 percent for every 10-percent increase in loan size.  An decrease in interest rates may not necessarily decrease total costs of borrowing by the same amount of the rate increase.  In the Dominican Republic, reductions in transaction costs for savers were the most important determinant of the success of deposit mobilisation (Gonzalez-Vega, 1993).  This is not an exception to the rule.
 Intermediaries' Transaction Costs


The intermediary 's aim is to cover the costs of both fund mobilisation and risks of lending, and to make a profit (Gonzalez-Vega, 1989).  The costs for the lender include costs of collecting information about potential borrowers, the expenses of mobilising funds to lend to borrowers, and the costs of extending, maintaining and collecting loans (Adams & Vogel, 1990).  Thus, the transaction costs of lending are the costs of administrating credit and the cost of default risk (Aryeetey et al., 1997).


Non-financial costs incurred by financial intermediaries may be grouped as costs to (1) mobilise deposits; and (2) costs incurred in the process of lending.  Costs to mobilise deposits can include all costs like labour, capital and materials used anywhere in the process of handling deposits.  On the other hand, lending costs are those associated with loan processing, disbursement, monitoring, recovery, obtaining information on potential clients and assessing validity of collateral offered.  In addition, the element of default, or the risk of granting a loan to the wrong borrower, also increases the aforesaid cost elements.  It is difficult to estimate the danger or potential of default, especially at a first contact between an intermediary and a client.  Hence, intermediaries follow diverse and usually undisclosed procedures in accounting for it.  This contributes to estimation problems of transaction costs of financial intermediaries (Coetzee, 1992).


Von Pischke (1996) refers to areas where people are not considered as creditworthy as the "financial frontier".  Transaction costs of formal financial institutions increase as they approach this frontier.  Depositors keep smaller and smaller savings, while transactions also seem to become small.  Turnovers in accounts tend to be high in relation to average balances held.  Other transactions such as money transfer or other fee-based services are also restricted.  Furthermore, these depositors prefer to use cash instead of checks or money orders for transactions.  This means that the intermediary has to keep relatively large amounts of non-interest-earning cash available. 


Borrowers at the frontier are often spread over wide geographical areas.  This hampers the ability of lenders to trace and contact them (Christensen, 1993).  In addition, these clients tend to be quite heterogeneous (Gonzalez-Vega, 1993).  Thus, this complicates and increases the costs to obtain and verify information from these applicants.  Borrowers may be unaccustomed to making timely payments.  They often lack collateral or credible guarantees.  Dealings with illiterate clients or those who do not speak the business language of the country or of the loan department staff consume more time.  Incomes of borrowers tend to be unsteady and loans tend to be small, while the sources of repayment are not always very clear.  Hence, financial transactions have a fixed-cost character (Von Pischke, 1996).


Rajasekhar (1996) points out three specific problems:

(a) screening problem - borrowers differ in their likelihood to default.  It is costly to determine the extent of that risk for each borrower; 

(b) incentives problem - it is costly to ensure that borrowers take those actions that make repayment most likely;

     (c) enforcement problem - it is difficult to compel repayment.


In addition, in the case of donor-driven credit, the cost of engineering a community (clients) to fit into a need which has been externally identified, could be very high. 


The programmes of ACORD, a NGO active in, among others, Uganda, could be regarded as successful when one considers the achievement of cohesive group formation, savings mobilisation and extension with regard to simple bookkeeping principles, interest rate policy and simple business profitability analysis.  The problems of these programmes, however, were the cost of operating the schemes, which, in some cases, far exceeded the value of loans granted.  Staff salaries were far above official Ugandan scales (Abugre, 1994).



In conjunction with what has been said earlier, the main indicator of a country's financial progress is a reduction in the level and dispersion of the transaction costs incurred by all.  The latter include actual and potential participants, as well as borrowers and lenders (Gonzalez-Vega, 1993).  Research has indicated that the costs of financial intermediation are not shared by borrowers and lenders in fixed proportions.  For example, intermediaries may find it their interest to absorb some of the transaction costs normally incurred by clients, for clients they prefer above others.  At the same time, an intermediary may force non-preferred clients to incur transaction costs normally absorbed by the intermediary, as a way to discourage them from making use of his services (Adams & Vogel, 1990). 


3.2.5 Interest Rates 


The Concise Oxford Dictionary (1990) defines financial interest as “money paid for the use of money lent, or for not requiring the repayment of a debt”.  The market rate of interest is that rate which cover the costs of funds, administrative costs, risks and an adequate profit margin (Seibel, 1994).


Many previous strategies used to promote rural finance blindly stared at interest rates as the only, or at least, most important factor that influences choice of intermediary.  Appendix III gives some insight on the role that interest rates played in financial development in the previous decades. 


If financial institutions are forced to lend at undifferentiated commercial rates, subsidised interest rates for certain clients are demanded, with the same consequences as any type of subsidised credit (Seibel, 1994).


Interest rates above the inflation rate alone are not enough to ensure healthy financial markets.  Appropriate interest rates should go hand in hand with policy and financial markets reforms in order to create a favourable economic environment that enhances sustainability (Spio, 1994).  Financial institutions must also be stimulated to rely on their own resource base.  This is hindered by inappropriate loan guarantees and liquidity provision (Seibel, 1994). 


Zeller et al. (1994) interviewed rural households in The Gambia.  This revealed that the problem is access to credit, rather than the level of interest rates charged.  Autonomously regulated village-based banks which charge relative high interest rates in relation to, e.g. NGO subsidised credit, confirmed it.  Rural Gambians were willing to pay these interest rates for timely loans.  In fact, the members of the village banks decided annual rates of up to 60 percent on loans and 40 percent on deposits.



Likewise, Aryeetey et al. (1997) found in several Sub-Saharan African countries that interest rates charged in segments of both the formal and the informal financial sector have little influence on each other, implying that it does not play a highly decisive role in choice of intermediary. 


Nevertheless, interest rates are critical in determining the performance of financial markets.  Favourable interest rates are necessary as an incentive for rural households to save in a financial form in order to strengthen the resource base of the national economy and to improve financial institutions’ viability (Coetzee, 1992).


3.2.6 Loan Repayment


Repayment default rates are measured in various ways, for example the collection ratio for an accounting period, the percentage of the portfolio in arrears at a given time, the proportion of borrowers who repay, and the repayment index.  If defaults are seen as loans overdue for repayment, it is difficult to determine how many of these loans will ultimately be recovered.  It has been found that the longer the arrears, the greater the likelihood that the loan will not be repaid (Von Stockhausen, 1983).


High default rates are especially related to subsidised credit programmes (see Appendix III).  Farmers in developing countries show a higher tendency to withhold repayment if there are no emotional tie between the farmer and the intermediary or if local savings do not contribute to the portfolio of the intermediaries (Coetzee, 1992).


Table 3.1 Estimated Percentage Loan Delinquency Rates in Developing Countries (Coetzee, 1992)



Arrears Rate



















Sri Lanka


Latin America:



Al Salvador




Traditionally, borrowers who failed to repay were divided into two categories: they were seen as either unable or unwilling to repay.  Recently, there has developed a trend of not making a distinction or division.  There is rather an increased awareness of the importance of incentives for both lenders and borrowers in determining loan delinquency.  At the basis of this recent view stand the costs and the benefits to a borrower of repaying or not repaying a loan.  A borrower may choose to repay because of the probability of receiving a larger loan in the future, on which a positive rate of return can be expected.  Against this must be weighed the explicit financial charges on the possible new loan, which include transaction costs involved in repaying the current loan and then negotiating and receiving the new one, as well as the timeliness of the new loan (Adams & Vogel, 1990). 


If the borrower chooses not to repay a current loan, two main outcomes are possible.  One is that the lender may do nothing, although future loans from this lender will most probably be denied.  Otherwise, the lender may take strong action so that the borrower may, for instance, lose collateral pledge for loans, in addition to denial of future loans from this and/or other lenders.  The probability of obtaining a new and larger loan in the future on a timely basis seem to be a very important determinant of loan repayment (Adams & Vogel, 1990). 


Delinquency in timely repayment is a sign that borrowers are not concerned about the survival of an institution or its future.  They will grasp loans while funds are available, especially in the case of cheap loans, but will not bet on the institution's survival.  Default weakens the institution and thereby, confirms the borrower's pessimistic presentiment.  As a result, a vicious circle arises wherein banks get trapped.  On the other hand, if loans are paid in time, it can be regarded as a signal that clients value the relationship with the intermediary.  The expectation of a reliable and continued access to valuable financial services is the most powerful incentive for the repayment of loans (Gonzalez-Vega, 1989). 


Koch & Soetjipto (1993) found that the loan period is negative correlated with the collection rate: the longer the loan period, the lower the collection rates.


In Indonesia, loans were lent to clients for 6 months or less, for 7-12 months and more than 12 months.  The average collection rates were 94 %, 90 %, and 82 %, respectively (Koch & Soetjipto, 1993).


The Concise Oxford Dictionary (1990) defines collateral as “security pledge as guarantee for repayment of a loan”.  According to Jordan (1995), the amount received from liquidating such an asset has to be enough to cover all, or at least most, of the lender’s risk exposure which include principal and accrued interest as well as collection costs.  Lenders usually demand collateral in order to assess the borrower’s creditworthiness and to increase the risk-adjustment return on the loan.  It is a security mechanism when information and knowledge about the borrower is limited.  Collateral is also often used as a major determinant of the lender’s decision to ration loan demand (Zeller, 1994).


Collateral can also be defined as a physical asset which satisfies the following three conditions:

(a)    appropriability, which refers to the ease of liquidating the collateral by the lender in case of default;

(b)    absence of collateral-specific risks, which implies that the collateral’s subjection to, e.g. theft, fire, disease, inflation, political risks etc. must be minimised;

(c)    accrual of the returns to the borrower during the loan period, which refers to the direct economic returns earned from the use of the asset, or the indirect economic returns earned from the investments made with loans obtained using the asset as collateral (Jordan, 1995).


However, collaterals in financial markets are generally discussed in the context of formal financial markets in developed countries.  Collateral, as defined above, is rarely used in less-developed economies where informal finance dominates rural financial markets (Esguerra & Meyer, 1989).


Small farmers do often not possess the required assets to use as collateral.  In many countries, both developed and developing, land is an important physical collaterals (Zeller, 1994).  Due to traditional land tenure systems, e.g. communal systems, many small farmers are not able to acquire credit through these means.  They have to rely on other assets such as livestock, jewellery, labour, etc. to secure their loans.  It implies that there is a positive relation between a farmer’s wealth and his/her access to credit.  This situation maintains equity problems.


Surveys done in two villages of Sri Lanka, Mabodale and Makkaduwawe, revealed that in that spesific case collateral requirements and guarantor arrangements are the main barriers to enter the institutional rural credit market (Zander, 1994).



Some credit programmes in the past did not require any collateral at all.  The general experience was that the rate of recovery was initially good but later declined.  This outcome is ascribed to less discrimination in the selection of borrowers, to less supervision of lent funds, or to more political interference and corruption as the credit programme progresses (Von Stockhausen, 1983).


However, there are also non-tradable assets of which the value is increasingly recognised, that help to enforce contracts.  They are referred to as collateral substitutes.  They include, among others, reputation, access to future loans, third party guarantees, and fear of social ostracism. Collateral substitutes are usually based on “inside knowledge” that informal lenders presume to have about their clients.  They often form the basis of informal financial arrangements (see chapter 6).  These assets are generally of more value for the borrower than the lender and they will not cover the lender’s loan loss in the case of default.  Nevertheless, they can be very effective to reduce moral hazard (Jordan, 1995) and proved to be an effective mechanism to enforce repayment in many financial transactions (Esguerra & Meyer, 1989). 


The appropriate collateral substitute in a transaction depends on the specific circumstances.  The use of specific collateral substitutes can be traced to the behaviour of lenders and borrowers in other factor and product markets.  So those borrowers are screened according to the type of collateral substitute that they can offer and that lenders desire.  It leads to specialisation in terms of borrowers groups (Esguerra & Meyer, 1989).


Ghate (1990) also points to collateral substitutes as an effective mechanism to enforce repayment, for example interlinking credit with marketing, employment or leasing transactions.


In practice, the kind of collateral/collateral substitute used, depends on the particular production, social, legal, economic and political environment of a country and are subjected to evolution over time (Jordan, 1995).


3.2.7 Segmentation, Fragmentation and Dualism


Aryeetey et al. (1997) define segmentation as the existence of multiple financial markets without cross-linkages, where distinct institutions serve clients with different characteristics and needs.  According to Von Pischke (1996), segmentation is not necessarily undesirable per se.  It may even lead to improved efficiency through specialisation for different market niches.  Hence, the main point is the extent to which these several segments are integrated.  Prices and terms of similar transactions are often comparable, which reflects a competition effect.  Specialisation also implies that differentiated risk and cost characteristics yield comparable risk-adjusted returns across segments.  The result is a financial system that is successful in its task, i.e. the mobilisation of resources and intermediation (Aryeetey et al., 1997).


Fragmentation indicates a lack of interaction within and between segments, i.e. a lack of integration.  It is often used in the sense of a situation where detrimental effects of weak linkages among segments outweigh benefits of specialisation.  It is characterised by wide differences in prices for the same product, high interest rates, insignificant flows of funds between segments, differences in risk-adjusted returns and limited access by clients to financial instruments and institutions (Aryeetey et al., 1997).


Where extreme fragmentation exists between formal and informal sectors it is referred to as dualism.  Thus, there is an inherent dualism of economic and social structures.  The modern and traditional financial sectors can be regarded as more or less discrete financial enclaves, even though their degree of formality could be expressed as a continuum (see 6.2).  This situation reflects an underlying production structure and distribution of wealth of an economy (Ghate, 1990).  Theoretically, the formal sector would be associated with an urban-orientated, institutionalised, organised system that is modern and monetised, while the informal sector would cater for the traditional, rural, non-monetised parts of the economy.  Yet, in reality, the division is not so clear.  There is sometimes a substantial flow of funds between the two sectors in both directions (Germidis, 1990). 


However, the formal and informal sectors face a great difference in their relative prices and flows between them are limited.  In countries where the development process was less successful, financial dualism seemed to have deepened over time and the two sectors often formed almost discrete financial enclaves (Aryeetey et al., 1997). 


Accurate categorisation of supply and demand for financial services between the formal and informal sectors is difficult.  The nature of the institutions and individuals involved in these financial transactions are diverse.  There is also diversity among public attitudes to different services.  Thus, there are different demand and supply structures for each sector and these ensure continued segmentation of the market.  Hence, it has implications on the relationships between them (Aryeetey, 1992b).


Fragmentation and dualism limit the efficiency of financial markets. This lack of substitutability between segments paralyses intermediation between savers and investors, in allocating financial resources, and in transforming and distributing risks and maturities.  Potential household savings go untapped and profitable investments can not be financed.  In such situations integrative mechanisms are needed to improve the efficiency of the financial system (Aryeetey et al., 1997).


A well-functioning system, on the contrary, is thoroughly integrated.  Formal and informal financial institutions are specialised for their respective market niches.  The integration lies in a flow of funds between them, as well as some degree of substitutability among institutions.  Substitutability results from overlapping clientele of separate institutions.  These clients can choose freely among institutions (Aryeetey et al., 1997).


There exist several hypotheses to explain fragmentation and dualism.  The financial repression hypothesis asserts that restrictive financial policies shift the allocation of investible funds from the market to the government, through indiscriminate control of financial prices.  It includes administered exchange rates, credit allocation, interest rate ceilings, etc.  This results in parallel markets in order to accommodate those crowded out by government intervention (Aryeetey et al., 1997).  In other words, the informal sector exists in response to the deficiencies and inefficiencies of the formal sector (Germidis, 1990). 


Coetzee (1992) also mentions that fragmentation results from the absence of a legal framework that can enforce the enactment of contracts.  Artificial fragmentation results from government actions, which aim to address perceived market failures through policy instruments.  Often the wrong instrument is chosen and additional distortions arise, adding to the already high transaction costs that exist in a specific market.


The imperfect information hypothesis blames inherent information problems as the source of segmentation and fragmentation.  It points at insufficient flow of funds or overlap in clientele among segments to equalise risk-adjusted returns.  It also relates to the great variation in financial technologies that lenders use in RFMs to screen borrowers and to enforce loan repayment.  These problems may not simply be overcome by liberalisation (Meyer & Nagarajan, 1991).  The high cost of obtaining information on, and transacting business with small clients persists for formal institutions.  It suggests that market failures result from adverse selection and moral hazard.  Weak legal systems, underdeveloped marketing support infrastructure and expatriate roots of banking in Third World countries further deteriorate financial integration (Aryeetey et al., 1997). 


Germidis (1990) points out another argument: there is an existing, intrinsic dualism of economy and social structures in LDCs.  It results from the fact that the rural population is attached to its traditional values and customs.  Therefore, financial dualism is just one aspect of the overall structural dualism of the economy.


According to Coetzee (1992), the extent of fragmentation depends on the magnitude of actual and potential transaction costs.  Transaction costs are described as a consequence of poor infrastructure and communication services, especially in remote areas.  Thus, this brings us back to the information problem.


However, the fact is that financial dualism limits economic growth through an adverse effect on accumulation and distribution processes in LDCs.  It results in sector and regional disparities in terms of mobilisation and allocation of funds.  The development of each of the two economic sectors depends for a great extent on the accessibility of their credit sources and therefore a difference in their growth rate emerges.  The formal financial sector seldom caters for small and poor clients.  These clients have to choose between higher-cost informal financial services and no financial services at all (Germidis, 1990).


Dualism undermines the implementation of a consistent economic, monetary, and financial policy.  Informal sector escapes taxation and its activities do not appear in the national accounts.  Due to this absence of aggregate economic indicators, it is it difficult for public authorities to determine the source of money supply and monetary targets and therefore, to define objectives.  It is also impeded by the capital flight that takes place through informal channels.  Regulation, e.g. through interest rates, is difficult if there is a significant amount of liquidity outside the formal banking system (Germidis, 1990). 


3.3 Conclusion


What could be regarded as a successful rural financial institution?  Although there are differences in opinion about how a successful rural financial institution could be defined, most core elements correspond.  The two main elements are (a) self-sustainability, and (b) substantial outreach.


(a)    Self-sustainability


This implies an institution’s independence from subsidies from outside, e.g. from governments or donors (Yaron, 1994) in its aim to be a permanent, rather than a temporally institution.  Furthermore, a borrower also expects a financial institution to be reliable in order to build a long-term financial relationship (Gonzalez-Vega, 1989).  It is important that a borrower has 100 % trust in the integrity of his/her financial intermediary (Thillairajah, 1992).


In order to achieve this, rural financial institutions should at least:

·         avoid loan subsidies, targeting and concessionary discount lines (Thillairajah, 1992). These strategies usually imply that RFMs are asked to do tasks beyond their inherent abilities (Adams, 1992);

·         have positive interest rates (Thillairajah, 1992).  This is essential to cover financial costs.  High enough deposit interest rates are required to ensure voluntary savings (Yaron, 1994).  Hence, it is necessary to continue to expand (Adams, 1992);

·         mobilise deposits (Thillairajah, 1992).  Apart from the fact that voluntary savings are necessary to finance the loan portfolio, it offers potential borrowers a systematic way of establishing their creditworthiness.  Lenders are hereby provided with expensive information that is useful in screening potential borrowers and impose more discipline on lending.  In order to assure financial viability, successful RFMs have to provide deposit services to a much larger number of depositors than borrowers (Adams, 1992);

·         achieve a high rate of loan collection (Yaron, 1994);

·         reduce transaction costs for both intermediary and client (Adams, 1992; Thillairajah, 1992).  Ensure favourable lending rates through efficient procedures for assessing investment plans, screening borrowers, processing loans, collecting repayments, as well as mobilising and servicing savings (Yaron, 1994).  Thus, financial institutions should develop appropriate technologies to carry out these procedures (Gonzalez-Vega, 1993).


(a)   Substantial outreach


It includes the following points:

·         focus on usually excluded clients.  Services should be accessible to all rural clients, including low-income clients, women or any other clients lacking access to financial institutions (Debar & Van Lint, 1995; Gonzalez-Vega, 1993);

·         client-appropriate lending.  It refers to quick, simple and convenient access to small loans, often on short-term, as well as the use of collateral substitutes (Debar & Van Lint, 1995).  Financial services should fit the needs of these clients (Debar & Van Lint, 1995; Gonzalez-Vega, 1993);

·         saving services.  The ideal would be if financial services facilitate small deposits, convenient collection, safety, and ready access to funds (Debar & Van Lint, 1995; Spio, 1994);

·         growth of outreach.  It reflects strong client response to services offered and competence in service delivery management (Adams, 1992; Debar & Van Lint, 1995).







4.1 Introduction


Both formal and informal financial institutions provide financial services, or rather supply financial “products”, in rural financial markets.  The distinction between formal and informal is usually made according to whether the institution is subjected to government registration, regulations and control as well as to the control of the central bank.  Formal status is usually a precondition for direct government promotion.  To be classified as “formal” usually determines whether or not the institution has access to development funds as well as other forms of support from their own country and from those provided by foreign donors (Schmidt & Kropp, 1987).


Formal financial institutions (FFIs) are structures transferred from abroad which seldom take into account the preferences and needs of the average saver in LDCs.  Despite of a wide-spread emergence of formal financial institutions all over these countries, it is clear that their track record is a sorrow one (Miracle et al., 1980).  The distribution of bank branches is mainly concentrated in urban areas (Germidis, 1990).  They are unsuccessful in tapping the savings potential from rural areas, while the default in loan repayment is almost uncountable.  In fact, the arrears' ratios in the formal sector are alarming and the droughts of the 1980s and the first half of the 1990s increased the problem.  In addition, formal institutions fail to sufficiently reach the rural poor, which really need such services (Miracle et al., 1980).


Despite of the implementation of reform measures, the deposit base of banks is volatile and no significant change has yet been observed in their liability structure.  Few innovation instruments and products have been developed, and bank loan portfolios have experienced no significant change.  Banks continue to concentrate lending on their traditional clientele: large, established customers.  In spite of liberalisation and the attempt to introduce greater financial competition, formal financial agents fail to significantly increase their accessibility to a large part of the population (Aryeetey et al., 1997).


4.2 Formal Institutions


In most developing countries, the central bank and commercial banks dominate the formal credit market.  Supply is mostly limited to short-term resources due to a lack of an effective capital market, although there are indications that this is slowly changing to longer terms.  Foreign investors and donors mainly supply long-term resources and, therefore, these resources are scarce (De Jong & Kleiterp, 1991).


According to Germidis (1990) and Meyer & Nagarajan (1991), the formal financial sector consists of three levels.  The central bank and other regulatory and prudential institutions represent the first level.  The second level is represented by an abundance of banking and non-banking financial intermediaries.  It includes commercial banks, development banks, postal saving networks, saving banks, insurance companies, building societies, etc.  Commercial and development banks are usually the most prominent.  These institutions are directly involved in providing borrowers and savers with financial services (Meyer & Nagarajan, 1991).


The third level refers to capital markets.  In developing countries they are represented by a multiplex of institutions including the relative atrophy of financial, bond, or stock markets in Africa as well as emerging capital markets in some Latin America and Asian countries (Germidis, 1990).  According to Meyer & Nagarajan (1991), they generally play an insignificant role in LDCs and Aryeetey et al. (1997) point out that they could play their full potential only at a later stage in economic development than that presently found in LDCs.  Therefore, they are seen as beyond the scope of this study. 


Banks are western institutions that were transplanted to developing countries.  Therefore, they usually provide purely financial services.  Formal sector bankers, being in white-collar employment, tend to be unfamiliar with the problems and constraints faced by many of their rural clients.  Many rural people feel uncomfortable in banks and with the banking personnel of the formal sector (Miracle et al., 1980).


4.2.1 Central Bank


The central bank and other regulatory and prudential institutions determine the "rules of the game" for most formal institutions.  These regulations have consequences for the formal and semi-formal financial institutions.  As a rule, it tends to play an interventionist role in local financial activities of developing countries (Germidis, 1990; Meyer & Nagarajan, 1991).


According to Adera (1995), central banks' development and promotional role in Africa is unsatisfactory.  They have not done much to deepen financial intermediation, to promote maturity transformation, to enlarge and widen portfolio choices of savers and investors, to reduce transaction costs, or to address regional and sector imbalances.  They also failed to monitor the activities of commercial banks sufficiently.  The regulatory function of central banks has also not effectively been pursued.  Lack of adequate capital and unrealistic valuation of assets resulted in declaration of unrealistic profits and dividends.  Furthermore, their attitude in relation to the informal sector can be describe as one of ambiguous “benign neglect” or even hostility and prejudice, because the informal sector is wrongly equated with the illegal, underground economy which is beyond the control of the central bank.  Aryeetey et al. (1997) also argue that central banks are generally incapable to deal with informal and semi-informal financial units.


4.2.2 Banking and Non-Banking Financial Intermediaries


It is often found that banks are required to follow administrative procedures set by the government.  In this situation they seldom learn from each other or from their own experience, leave alone from local or informal financial institutions.  Loans are uniformly allocated according to defined production goals.  Administration delays have no impact on lending decisions.  Loan collection tends to be passive with no social controls at all.  Active savings collection is usually badly neglected.  Moreover, loan sizes, maturities and grace periods are not individually determined.  Quarterly or seasonal instalments are often used, instead of accommodating individual repayment capacities deriving from other income sources.  Penalties are not always enforced, which lessens incentives for repayment (Seibel, 1994).


As a result of liberalisation, many banking systems are being strengthened in various ways, for example by improved supervision.  However, they have so far tended to focus on their best clients to improve portfolio performance, rather than reach out to new, smaller clients (Aryeetey et al., 1997). Commercial Banks


According to Schmidt & Kropp (1987), large commercial banks, as found in western countries, have been regarded as capable to function in a dynamic and efficient way.  The structure of these institutions is mostly transferred from abroad to developing countries with little thought for the needs and preferences of the average local saver and borrower (Adera, 1995).  They are the most dominant formal financial institutions in LDCs (Aryeetey et al., 1997) and are normally found in urban areas.  Thus, their efforts to improve the range and quality of rural financial services are usually not very successful.  They have no interest in lending to small farmers because the risk of default and transaction costs are high, and an acceptable collateral can rarely be provided (FAO, 1994). 


It is doubtful if commercial banks possess the necessary know-how to fulfil the task of financing innovative investments, which are needed to stimulate development, and the follow-up services in these areas.  Managers of commercial banks are seldomly trained to cope with agricultural problems.  The problem is aggravated by the rotation of managers, whereby relations with the community can not be established.  These relationships, however, are essential for managers to acquire the knowledge necessary to efficiently screen and administer agricultural loans (Hartman, 1985).  It is also doubtful that they consider innovative financing in rural areas as an important element of their business strategy (Schmidt & Kropp, 1987).


Their activities in rural areas are mostly limited to financing commercial farming and co-operatives with government guarantees (Hartman, 1985).  When they do provide other rural financial services, they primarily accept savings deposits in these areas, which are then mostly transferred to urban areas (Mauri, 1983).  These deposits, however, are seldom used to provide loans in rural areas.  In fact, credit is seldom extended within rural areas, and especially not to target groups in the poorer rural population (Schmidt & Kropp, 1987). 


In Tanzania, commercial banks are seen as agencies that sell government debt by baiting private agents’ deposits and then conveying these funds to public institutions.  Even if they are rural institutions, little credit is passed on to farmers as loans that could be used for e.g. consumption (Dercon, 1996).  On the other hand, rural banks that are only active on a regional scale do not exhibit the often negative effects of transferring funds from rural into urban areas.  However, their services are usually also not extended to target groups (Schmidt & Kropp, 1987).  The result is thus that very little credit reaches the peasant in rural areas.  In African countries, many commercial banks prefer to invest excess liquid assets in treasury bills and government bonds, where risk is marginal (Adera, 1995).


Few African governments have deliberately directed the lending pattern of commercial banks to stimulate development-oriented investment, e.g. industrial activities.  Moreover, there is a latent demand for credit by small borrowers, which remains unsatisfied, while the banking sector accumulates excess liquidity.  This further lessens the support from productive investment.  This situation can give rise to a “low lending trap”, whereby efficient resource allocation is hampered and the emergence of entrepreneurship is impeded.  Many commercial banks are often unable to deliver credit without elaborate paperwork and complicated collateral requirements.  This factor alone is enough to steer many potential clients away from the formal sector.  In addition, in some countries there is a distrust in government and associated institutions, because of a fear of interference, control, taxation or outright confiscation (Adera, 1995). 


Schmidt & Kropp (1987) argue that the prevailing regulation of interest rates and prices of commercial banks in most countries is one of these institutions’ major constraints with regard to the provision of credit in rural areas.  It precludes the profitability of loans (see Appendix III.1 Subsidised Finance).  The relatively few commercial banks that do have rural credit programmes usually consider and execute them as welfare projects and public relations activities that are not expected to cover their costs. Development Banks


These banks were created to fill a gap in the institution system where other banks were lacking (Schmidt & Kropp, 1987).  Development banks were initiated, on the initiative of national authorities, to fulfil the lacking demand for long term credit (Lambrechts & Debar, 1995).  They are often found in the form of specialised agricultural banks dealing with individual farmers (Argyle, 1983), although Adera (1995) points out that in practice many turn out to cater mainly for the manufacturing and mining industry.  Most of them are government or para-governmental banks, specialised in the credit business and partially or wholly financed by foreign donors, the national government and/or the central bank.  The acceptance of savings deposits or savings mobilisations is usually not within the scope of these institutions (Schmidt & Kropp, 1987).  These institutions have in practice become mere retailers of foreign loans and government funds, although many were empowered to mobilise resources when they were established.  Their high operating costs and slow loan recovery cycle erode their capital base for onward lending to a diverse set of customers (Adera, 1995).


According to Lambrechts & Debar (1995), there are several factors that made development banks fail.  They are accused of high operating costs, inadequate consecution of credit dossiers, strong political influence, incompetence to cover their own banking costs, and credit conditions that are too strict.


For the past few years, development banks have been reoriented to broaden their field of intervention by supplying credit to small and medium-sized enterprises as well (Schmidt & Kropp, 1987).  Yet, successes in this field were rather exceptions, whereas small-scale enterprises and small farmer have not yet tasted much of the potential benefits (Adera, 1995). 


In general, development banks failed in their newly orientated role.  They did not reach the targeted groups of small-scale enterprises to a sufficient extent and/or they did not prove themselves to be stable and efficient institutions.  This may be due to the fact that their business policy was, and still is, more orientated towards implementing government policies than serving the needs of clients (Schmidt & Kropp, 1987).


4.3 General Shortcomings of Formal Financial Institutions


According to Von Pischke et al. (1983), it is the performance of government lending institutions, i.e. formal institutions, rather than that of borrowers that need most improvement.  From the forgoing discussions it is clear that there are numerous reasons to explain the disappointing performance of formal rural financial institutions in rural areas.  They can be summarised by means of a few broad categories.


4.3.1 Formal Financial Services do not Reach Rural Clients


FFIs are mainly urban-orientated, while state- or donor-sponsored credit programmes often reach only a minority, often the wrong minority, of the rural population, i.e. the wealthy and influential farmers (Yaron, 1994).  As a rule, higher income farmers interact more with formal institutions as sources of inputs and market outlets for their produce, than farmers from lower income groups (Germidis, 1990).


FFIs tend to prefer to deal with large amounts of both savings and loans, due to the high transaction costs incurred through documentation, legal fees, loan appraisal, etc.  Hereby, the majority of potential rural clients in LDCs are excluded (Germidis, 1990).


Zeller et al. (1994) also found that in The Gambia, the level of household income has a significant effect on whether an individual received formal credit or not.  The Gambia is no exception to the rule, this phenomena is seen in all LDCs.  Therefore, those that are in real need for credit, i.e. the poor, are not reached.


Moreover, the formal financial system often does not have the capacity to serve small borrowers.  Many rural areas lack access to formal financial services, despite all extensions done by the formal financial sector the last few decades (Aryeetey, 1994).  Cuevas (1989) points at poor conditions of communication, rural infrastructure and transportation.  Macroeconomic conditions and financial regulations often hinder these institutions to directly provide financial services in rural areas.


FFIs have a triple bias regarding the mobilisation and allocation of resources.  There is a preference for:

(a)    the public sector over the private sector;

(b)    large-scale enterprises and upper-income households over small-scale enterprises and lower income households;

(c)    for non-agricultural (construction, manufacturing, commerce, industry) over agricultural loans (Germidis, 1990).


According to Adams (1989b), formal intermediaries mainly focus on their major sources of funds.  Depositors and borrowers of small funds are often treated as a nuisance.  Formal intermediaries have no incentive to establish quality relationships with these clients.  It stands in sharp contrast with informal finance, where financial relationships are usually build on personal ties.


4.3.2 FFIs Fail to Provide the Financial Product that Rural Clients are Looking for


Lower income groups avoid FFIs because of these institutions' rigid, bureaucratic procedures with loan disbursement and deposit-taking.  Long travelling distances, various processings, slow disbursements and cumbersome paperwork are too much for many potential rural clients.  A significant part of them are often illiterate (Germidis, 1990).  All these procedures lead to high transaction costs and long waiting periods to receive loans (Yaron, 1994).  Nagarajan et al. (1994) also stress that the inability of many FFIs to provide credit on the point of time when borrowers need it, as well as elaborate paperwork which is needed to carry transactions through, steer many potential clients away from FFIs.  Rural communities place a higher premium on convenience, accessibility and trust than on nominal interest rates (Aryeetey, 1994).


Many rural borrowers can not meet the collateral requirements demanded by FFIs (Germidis, 1990).  Credit controls may prevent the formal sector from making loans for a variety of purposes, including consumption loans, so that the borrower has no alternative than to make use of informal financial opportunities (Ghate, 1990).


4.3.3 High Transaction Costs


Formal finance most often implies a lot of paperwork, delays, and fees, while bribes are not excluded (Lee, 1983).  It subjected to a variety of regulations relating to capital, which my include reserve and liquidity requirements, ceilings on lending and deposit interest rates, mandatory credit targets and audit and reporting requirements.  This, together with internal bureaucratic procedures, raise transaction costs in the formal sector to levels usually well above the informal sector (Ghate, 1990) (see Appendix V for an illustration on the difference in costs incurred by the formal and the informal sectors).


4.3.4 Neglecting Savings Mobilisation


Adams & Vogel (1990) refer to saving mobilisation as the forgotten half of rural finance.  Many FFIs have thus ended up as mere disbursement windows, rather than balanced, full-service financial institutions (Yaron, 1994). Despite the fact that there is a very promising potential of savings mobilisation in rural areas (Miracle et al., 1980), transaction costs in relation to deposit amounts of rural savers are very high.  FFIs tend to devote most of their energy to credit allocation for highly productive investments, to create money as quick and cheap as possible.  They neglect, however, the mobilisation of household savings (Germidis, 1990).


Low, often negative, interest rates seem to be the major reason for low saving mobilisation rates (Adams & Vogel, 1990; Lee 1983; Yaron 1994).  Depositors are forced to make use of less productive savings alternatives while funds are limited to relative few, usually wealthier borrowers (Lee, 1983).


4.3.5 Internal Structure


FFIs find it important to exert control over the use of funds.  They want to ensure that loans are used for productive and, preferably, long-term investment projects.  It implies that they exclude a lot of would-be clients for whom consumption credit may sometimes be a requisite before productive investments can follow (Germidis, 1990).  Lee (1983) argues that FFIs are too rigid, for instance, through inflexible minimum transaction requirements.


Nevertheless, formal channels for legal contract enforcement are inadequate in many LDCs.  The absence of proper administrative machinery has also been a reason for high loan delinquency, e.g. in Nigeria (Aryeetey et al., 1997).  Many FFIs suffer from inadequate credit evaluation, management, and monitoring, which result in poor loan collection (Yaron, 1994).


Despite reforms many FFIs in LDCs have not yet developed the capacity for risk management.  In fact, they still operate in an extremely constrained environment, with underdeveloped market-supporting infrastructure and poor information base.  They have become too hesitant regarding risk in their asset management (Aryeetey et al., 1997).


Furthermore, according to Temu & Hill (1994), rural people are reluctant to accept formal finance, because of their adherence to traditional practices that have served their saving and borrowing needs for a long time.


4.4 Superiority of the Formal Financial Sector


Despite all the failures of formal finance in developing countries, it has several important characteristics which make it indispensable as financial intermediary.  Several major points contribute to its superiority.


·         Formal financial services operate on a global scale.  They have formed networks that tie them together nationally and internationally.  Hence, they can exchange money from one currency to another (Argyle, 1983).  Modern telecommunication enables them to move money in larger sums and over greater distances at short notice (Guate, 1990; Von Pischke, 1996).  Therefore, there is interaction within the formal sector (Aryeetey et al., 1997).


·         FFIs are protected by legislation, controlled by a central bank that guards against breaches of monetary policy and supported by the state and the national and international banking community.  Therefore FFIs could be steered by policies in the direction deemed appropriate, although side-effects are difficult to predict (Von Pischke, 1996).


·         Banks are able to lend large amounts of capital over long periods of time (Von Pischke, 1996).  This is possible because they have a greater reliance on the pooling of deposits and maturity transformations.  Therefore, they enjoy greater economies of scale and of scope.  It implies that FFIs are better suited to the large- and medium-scale needs of clients (Ghate, 1990).


·         Banks are able to provide a range of services, e.g. they can receive farmers deposits and provide credit on a variety of terms (Argyle, 1983), although their specialisation often leaves much to be desired (Ghate, 1990).


In short, formal financial institutions have the potential to provide dynamic and efficient financial services, as has been proved in First World countries.  Formal finance is the only means whereby a country can connect with the global financial network (Schmidt & Kropp, 1987).





5.1 Informal Finance


No standard definition exists for informal finance (Meyer & Nagarajan, 1991).  According to Von Pischke (1996), informal finance can be described as borrowing among individuals and firms that are not registered with the government as financial intermediaries and are not subject to government supervision.  However, there are countries that have usury and other laws that take informal financial arrangements into account (Meyer & Nagarajan, 1991).  Larson et al. (1994) describe informal financial transactions as the creation of financial asset and liability contracts without the intermediation of FFIs, e.g. commercial banks, development banks, etc., whereby these contracts escape the control and review of monetary authorities, i.e. central bank. 


Informal finance is extremely diverse (Adams, 1994).  Due to the fact that, by definition, governments play no role, credit supply takes on completely different forms concerning organisational structures and the supply of funds (De Jong & Kleiterp, 1991).


It is mostly conducted within broader relationships, ranging from kinship, friendship, customary social bonds, etc.  These financial transactions are embedded in multifaceted relationships that implicitly tie other activities to saving and lending (Adams, 1994).  It also includes credit associated with commercial transactions and land tenure arrangements.  Informal financial activities are active in both rural and urban areas, but are in general more important in rural areas (Germidis, 1990). 


The informal sector plays an indispensable role in rural economies of LDCs (Shanmugam, 1989), because it is the only source of financial services for the poor, the landless, and those living in isolated regions (Meyer & Nagarajan, 1991). 


The extent to which the informal financial sector's activities are entrenched in the general operation of the economy, its linkages to other sectors, as well as the strengths of various aspects of its operations, vary across countries.  In some countries informal savings mobilisation flourishes, while in other countries informal financial activities are limited to credit activities (Aryeetey, 1992a).  According to Christensen (1993), the informal financial sector increases in importance in proportion to the level of underdevelopment. 


In Malawi, the informal financial sector is estimated at three times as big as the formal sector.  Informal credit in Ghana seems to be four to five times more important as formal credit.  In Cameroon, approximately 75 per cent of rural financial assets and obligations stands on the account of the informal sector’s tontines.  In Zambia and Zimbabwe, respectively 43 and 87 per cent of farmers’ credit needs are met by informal arrangements (Adera, 1995).



It is extremely expensive to conduct surveys that investigate the relative importance of informal finance to the entire economy.  This is because of heterogeneity, small transactions, legality questions, and dispersion of informal finance.  Therefore, if figures are given, they are usually based on rough estimations.  Nevertheless, there are enough indications that informal finance plays a very significant role in developing countries (Adams, 1989a).


Informal financial operations depend on the traditions and values of the societies in which they operate.  Therefore, these financial markets vary between different people and regions and with different customary values and attitudes to finance (Ibe, 1990).  Characteristics intrinsic to the household/non-corporate sector have an important bearing upon the way financial systems function in the economy, explaining both the relative size and vivacity of the informal financial sector (Aryeetey et al., 1997).


Rural households are increasingly shifting away from the traditional non-monetary forms of savings, e.g. livestock, stocks of agricultural products, household assets and other valuable property, toward monetary forms of savings.  More liquid forms are necessary to finance children's school fees and to buy other commodities, or to expand investments.  Nowadays, money is also used to cover irregular expenses such as funerals and weddings (Bagachwa, 1995).


Seasonality is an important determinant of IFI economic activities in these areas.  Money revolves around the harvest season.  As can be expected, lending activities flourish when harvests have been poor, while repayments are highest immediately after good harvests.  The informal sector thus operates largely part-time (Bagachwa, 1995).


The large majority of informal finance consists of transactions that are not provided by formal agricultural credit programmes such as deposits, small loans and short-term loans (Adams, 1989b).  The informal money supply operates in those niches in which FFIs do not dare to tread due to high risk, low returns and other possible disadvantages (Schrader, 1992).  Therefore, despite the informal sector's own dynamics, the structure and the functioning of the formal sector are important factors that influence the nature and extent of informal finance (Germidis, 1990).


Adams (1989b) argues that informal finance is so successful because it depends on “inside money”, i.e. voluntary savings, while formal finance often heavily relies on “outside money”, i.e. governments or donors for funds.


5.1.1 Types of Informal Finance


There is a multiplicity of informal financial arrangements.  Some of them are centuries old, and most of them are constantly evolving, following the changes in society and economy (Adams, 1989b; Miracle, 1980). 


Credit markets in LDCs are a matching system where different borrowers are sorted across different lenders according to the lender's ability to screen its borrowers and enforce contracts.  Informal financial units serve distinct niches, which mean that each segment of the informal financial sector designs its loans to satisfy the needs of a specific group.  Informal finance is able to tailor financial contracts to satisfy the dimension, requirements and tastes of the individual lender (Aryeetey, 1994).  An important principle behind this is that informal financial units have been developed in response to the demand of distinct clientele (Aryeetey et al., 1997).


Three basic types of informal financial operators can generally be distinguished: groups of individuals organised mutually (associations); individual moneylenders; and partnership firms (Germidis, 1990).


The following gives a broad outline of the categorisation of informal finance as found in LDCs.  It is impossible to provide a clearly demarcated classification system, because this sector is extremely heterogene.  Each and every informal financial system is a dynamic system, shaped by its own unique socio-economic environment to something that best fits the service provider and the client in their environment. Self-Help Groups


Bouman (1995) and Llanto (1990) defined self-help groups (SHGs) as voluntary associations of people at grassroots level that are formed in order to cope with the difficulties of conducting economic and business activities in the rural economy.  These groups are usually autonomous, self-sufficient, self-regulated and self-controlled (Bouman, 1994).


The members are held together by the common objective of overcoming problems (both economic and non-economic) that affect the well-being of group members (Bouman, 1995).  In general, groups are usually formed on the base of the same interest.  This fosters the building-up of mutual trust and enhances group homogeneity.  Homogeneity is an important pre-condition for dealing with complicated financial matters.  People in a group usually have common bonds, e.g. they are living in the same area, have the same profession, the same religion, or they are from the same ethnic group.  They expect that members in the group will help them to achieve their individual goals (Koch & Soetjipto, 1993).  Zeller et al. (1994) also point out that access of poorer households to informal financial services in group-based schemes is usually positive correlated to the degree of social cohesion and democratic participation of members within the group.


A survey was conducted in Indonesia where groups, which practice financial activities, were asked what their major common bonds are.  The results were as follows:

·       the major bond is the same living area (85 %);

·       nearly half of the groups (43 %) have common social activities (e.g. family planning and family welfare-related activities);

·       another half (42 %) have the economic activities or the same profession;

·       and for 30 % religion is the common bond (Koch & Soetjipto, 1993). 



Groups are continuously evolving, adapting to changing conditions. The most important factor that influenced the spread and development of SHGs is the growth of the commercial and monetary economy (Bouman, 1995).


Self-help groups appear in many forms.  The core element is that they are organised, owned, operated and controlled by the members themselves.  Member meetings may be conducted on a regular or irregular base (Koch & Soetjipto, 1993).  These groups often operate as "clubs" with their own "rules of the game" to ensure that members stick to their contracts (Llanto, 1990).  They are especially important in Africa and in Islamic countries (Adams, 1989b).


In sub-Saharan countries a variety of examples of indigenous groups exists that provide mutual help at village level.  They are called  nnoboa and susu in Ghana, demisenu tons in Mali, tons in Senegal, in Ethiopia iddir and in The Gambia kafos (Nagarajan et al., 1994).


It has been postulated that kafos were formed in the early sixteenth century in areas currently called The Gambia when the majority of the tribes now found there migrated from Mali.  These groups were primarily active in implementing self-help public works, for example, well digging, building houses, village cleaning and sometimes the cultivation of crops for households with a lack of family labour.  Providing labour to kafos was mandatory, and refusing to do so was punishable.  Members also participated in organising social and political activities within the village.  Today, kafos provide mutual help in several ways: insurance against individual and aggregate risks and uncertainties; informal savings and contingency credit activities as well as other social relationships that ensure mutual help (Nagarajan et al., 1994). 



A group leader may be appointed.  Sometimes commissioned agents manage the group (Adams, 1989b).  According to Balkenhol & Gueye (1994) the group’s manager is a great influential factor in the success of a financial SHG.  He/she is usually chosen on the basis of personal and financial considerations.  Therefore, he/she has to be reliable, trustworthy and respected by all members.  Such a person must be someone with sufficient authority to impress members to live up to their contribution obligations and with the capacity to enforce sanctions.  Moreover, he/she must be able to resist the temptation of helping themselves with the funds (Balkenhol & Gueye, 1994). 


Bouman (1995) summarises the functions of SHGs in three main points: (1) security or insurance; (2) economic; and (3) socialising.  These functions are fulfilled by serving several purposes, for example:


·                  to pool labour, goods or cash for purposes of social security by creating insurance mechanisms against loss of income or harvest, accident, illness or death.  At another level the pool could be used for community development projects to improve public facilities like churches, temples, mosques, roads, bridges, schools, dispensaries, etc. (Bouman, 1995).  According to Miracle et al. (1980), pooled funds may be used to make bulk purchases or exercise monopoly power, while Adams (1989b) refers to some groups that administer an enterprise together and then invest the funds collected in this business.


Ibe (1990) reports that many of the village societies found in Awka Town, Nigeria, were not initially started in order to provide financial services, but rather to perform certain communal tasks.  Individuals living in the same area, who share common interests, easily form associations.  Regular contributions in these organisations are usually intended as a way of saving money to finance something that is of communal interest.



·                  some groups have several functions; they may combine religious, recreational, occupational and other functions.  In addition to their primary objectives (singing, dancing, praying, exchange of intelligence and craftsmanship) they often have financial activities as secondary functions (Bouman, 1995).


As a result of growth in organisation funds in several village societies in Awka Town, and due to the changing needs of members, these organisations started to provide surplus funds as credits to needy members (Ibe, 1990).


In The Gambia, indigenous informal groups are usually also multifunctional, endogenous and most often homogenous in terms of members' age, ethnicity, gender and occupation, but they vary in membership sizes (Nagarajan et al., 1994).



There are also traditional groups, sometimes referred to as tontines, which mainly serve as financial institutions, with saving and lending as their primary objective.  They are adapted to the informal sector where incomes are uncertain and where there is considerable social pressure on those with visible liquidities (Balkenhol & Gueye, 1994). 


If the group’s fund has a more or less permanent character, it is referred to as an Accumulating Saving and Credit Association (ASCRA).  If the case of a fund with a rotating character, it is called a Rotating Savings and Credit Association (ROSCA).  In essence, these groups are building reciprocal credit possibilities through their deposits (Bouman, 1995).  Savings and loan associations can offer members several other economical benefits, for example exchange of economic information, organising beneficial joint action or assistance and helpful guidance from others in managerial aspects of their business such as farming (Miracle et al., 1980).


Tontines in Dakar and some in Senegal appear to have originated as women groups.  It allows women to obtain a certain level of financial independence.  Another reason could be that women are more involved in the organisation of social events (Balkenhol & Gueye, 1994). Accumulating Saving and Credit Associations (ASCRAs) 


Many ASCRAs resemble banks of the formal sector.  Members deposit savings at regular or irregular intervals with a treasurer who holds it for safe keeping and returns it after a period that the participators have decided upon (Bouman, 1995).  There are usually several hundred members involved (Bouman, 1994), it can even involve a whole community (Balkenhol & Gueye, 1994).


Mostly the treasurer lends the pooled money to other members and sometimes to non-members as well (Bouman, 1995).  The loan decision is made by a board or subjected to the consent of members.  Collateral is often required.  Records are kept and loan administration tends to be extensive (Bouman, 1994). 


Non-members that borrow from an ASCRA are usually charged interest.  In some cases borrowing members also have to pay interest, but normally less than non-members (Bouman, 1995).  Bouman (1994) reports that high interest rates to borrowers are not uncommon.  It may be as high as 10 to 15 per cent a month, which makes the fund accumulate very fast.  This increases the opportunity for borrowing as well as the value of member’s savings.  Interests earned are ultimately distributed among members.  Sometimes the aggregate savings, or a part of it, may be used to finance a project that will benefit the entire group, e.g. building a dam, a school, etc. (Bouman, 1995). Rotating Savings and Credit Associations (ROSCAs)


ROSCAs are the most famous type of SHGs.  It is a universal practice that is centuries old.  The Kye in Korea date back to the 9th century, while in Africa the first Yoruba ROSCA, called esusu, originated around 1600 in Southern Nigeria.  ROSCAs form an integral part of a social security network that exists all over the world (Bouman, 1995).


It can broadly be defined as people that, by agreement, form an association to pool fixed contributions to a pot at fixed intervals. The pot is then given, in whole or in part, to each contributor in turn (Adams & Canavesi, 1989; Bouman, 1995).  The amount to be contributed, or the size of the contribution, by each individual is usually decided on consensus.  There are significant variations in contribution sizes among different associations (Aryeetey, 1992a).  The contributions to the pool may be in money, labour or goods.  The agreement and the association end when each member has had his turn from the pot (Bouman, 1995).  Typically, membership varies between six to fifty individuals and therefore ROSCAs are remarkably smaller than ASCRAs (Adams & Canavesi, 1989; Bouman, 1994).  Normally, members are allowed to make multiple payments to the pool.  In this context a member collect from the pool as many times as he/she contributes to it.  It allows the better-off members to boost the size of the fund and also improves their own access to lump-sums (Aryeetey, 1992a). 


The decision as to who will receive the pot may be determined by bidding (Shanmugam, 1989), drawing lots (Adams & Canavesi, 1989), age, social standing, need (Miracle et al., 1980), etc. 


Hence, when the cycle terminates, the process may start again.  The group may decide to increase or decrease their periodical deposits, the number of members, or the frequency of meeting.  Usually, the order in which the members get the collective deposit changes with each cycle (Miracle et al., 1980). 


The type of resources that are pooled, the rules that the members agree to abide to, in fact the whole nature of a specific ROSCA, depend on the needs of members and the ingenuity of the organiser.  It is also related to changes in circumstances (Bouman, 1995; Miracle, 1980).


One of the biggest advantages of ROSCAs is that all the members, except one, can acquire the amount of the pot sooner than if they would have had if they saved on their own (Adams & Canavesi, 1989).  In other words, unless a sort of interest is charged, all members of the group, except one, are able to borrow from the rest of the group at a zero rate of interest.  If there is any inflation, the real interest will be negative.  The last person to receive the pooled fund gets what he would have had if he had saved the required deposit each period on his own (Miracle et al., 1980).


Another advantage is that savings are not left idle, as they would be if kept, for instance, under the mattress, but are automatically lent to other members of the group (Miracle et al., 1980).  Therefore, savings are secured against theft, natural hazards like fire, illness (livestock) or pests like rodents and termites (crops) (Shanmugam, 1989).  Moreover, administration costs are kept low by the fact that no costs are incurred for safekeeping of money (Aryeetey, 1992a).


Traditionally, ROSCAs had, and still have, several functions: insurance, socialisation and economic support.  Insurance has been the basis of many ROSCAs.  Increased monetarisation and commercialisation since the 1960s, shifted the emphasis to the economic function (Bouman, 1995).  Adams & Canavesi (1989) also state that ROSCAs may evolve over time as economic objectives strengthen against social functions.  However, many ROSCAs still play an important social role as well.  Shanmugam (1989) reports that in Malaysia participants normally gather on days of disbursement, and the serving of refreshments is quite common.  It gives the members a feeling of "togetherness" (Adams & Canavesi, 1989).


The rate of default in ROSCAs is relative low in comparison to other credit schemes (Aryeetey, 1992a).  This is because the selection of members by the organiser or other members is usually based on personal knowledge and therefore, possible defaulters are eliminated (Shanmugam, 1989).  Miracle et al. (1980) also explain the low rate of default in terms of institutional safeguard and community pressure.  Moreover, a defaulter would hardly be accepted again in another financial transaction with that specific community.  Default on payment is a stigma (Shanmugam, 1989).


However, Aryeetey (1992a) reports that growing economic difficulties have put several of these associations under strain.  The cases of default are increasing.  This may be attributed to low income, e.g. poor sales and the rising costs of living.


According to Balkenhol & Gueye (1994), a hybrid of ROSCAs and ASCRAs also exists.  In this scheme members leave 5 to 10 % of the distributed sum with the manager to build up a separate common fund facility.  However, the latter is not used for on-lending purposes, but rather to finance social investments or part of it, like festivities. Individual Moneylending


Germidis (1990) divides individual moneylending in (1) non-commercial arrangements that include friends, neighbours, and relatives; and (2) commercial arrangements.  The credit activities of the latter could be  (i) money-based; (ii) land-based; or (iii) commodity-based. Friends, Neighbours and Relatives


Loans from relatives and friends are the most common form of informal finance.  Many of these loans involve no interest or collateral and many have open-ended repayment arrangements.  An important feature often found in these arrangements is the expectation that the borrower is willing to provide a loan to the lender sometime in future.  If access to other forms of finance is weak, this reciprocity may be an important way of risk management.  Therefore, these people put high priority on establishing and strengthening interpersonal ties (Adams, 1989b; Temu & Hill, 1994).


A disadvantage of such interpersonal transactions is that pooled savings are not always channelled to superior investments.  This phenomenon can be described as a vehicle of, so- called, dis-intermediation, because it impedes efficient mobilisation and allocation of savings.  It may even stimulate the fragmentation of financial markets (Temu & Hill, 1994). Moneylender


The moneylender is a typical example of a money-based commercial arrangement (Germidis, 1990).  Of all informal financial arrangements, moneylenders most probably receive most publicity.  They are remarkable sources of loans especially in Asia, but in Africa they are also common.  Usually their loans are granted for short periods, and collaterals may, or may not be necessary.


Moneylenders may engaged in this activity full-time or part-time.  Full-time moneylenders may be registered as such.  Part-time moneylenders occasionally use surpluses from their other business activities, such as trading, to lend for short term, mostly at very high interest rates.  In both cases, moneylenders usually use their own savings to grant loans, rather than intermediating third-party savers and borrowers (Aryeetey & Steel, 1996).


Hartman (1985) describes moneylenders as flexible and available, with knowledge of the borrowers' home and economic-commercial environment.  They usually have daily contact with their clients, which leads to comprehensive information about them.  Clients often have long-standing credit relationships with "their" moneylender (Schrader, 1992).


The greatest point of critic is that they often charge extraordinary high interest rates (Adams, 1989b; Cuevas, 1989; Hartman, 1985).  It is usually ascribed to a case of monopoly profit (Schrader, 1992), which results in a wide range of nick names e.g. loan-shark, exploiter, usurer, etc. (Adams, 1989b).  However, upon closer investigation it is often found that the share of monopoly profit is rather low compared to opportunity cost and risk premium.  Borrowers often ask for short-term and even one-day's loans to use as working capital.  It is, therefore, not fair to compare these loans with formal loans on basis of annual interest rates.  Formal credit possibilities can not be considered to be alternative because they do not lend for such short periods (Adams, 1989b; Schrader, 1992).  Aryeetey (1994) points out that access is much more important than interest rates.


In Latin America, street vendors occasionally borrow from moneylenders in the morning to cover their sales for the day.  In the evening they repay these loans.  Loans are typical in the order of ten dollars and then the required repayment is eleven dollars.  If this is calculated on an annual base the interest rate is 3,500 percent!  However, the loan allows the vendor to earn daily incomes that are several times the value of the loan (Adams, 1989b).



Furthermore, moneylenders are an open source of credit to the general public and the borrower does not have to satisfy any distinct conditions, for example, membership of a group.  Several borrowers may prefer to use a moneylender, because they can be almost certain that their loan request, regarding amount, time of disbursement and repayment period, will be met.  Other moneylender-clients are those that were precluded from other informal financial associations or were refused formal credit.  Therefore, it can be expected that many clients of moneylenders are highest-risk borrowers (Aryeetey, 1994). Mobile Informal Bankers


Mobile bankers are another example of money-based commercial arrangements (Germidis, 1990).  This system is found in countries like Benin, Burkina Faso, Gambia, Ghana, Niger, Nigeria, Sierra Leone and Togo, in other words, mainly in West Africa (Aryeetey, 1992a; Aryeetey & Steel, 1996; Miracle, 1980).


Mobile bankers are usually active at market places.  Individual savings collectors collect an agreed amount from each client every day and at the end of the month return an amount equal to the sum of the deposits minus a certain part (usually one-thirtieth, or one day's deposit), which is the banker's fee (Aryeetey, 1992a; Aryeetey & Steel, 1996).  The fact that collectors live and work in the same place as their clients, seem to be sufficient to provide a sense of security for those who entrust there savings to them (Aryeetey, 1992a).  In Asia, daily collections are often used to obtain loan instalments, rather than to mobilise savings (Aryeetey & Steel, 1996).


Mobile banking usually has an impersonal nature between participators.  Many clients prefer it this way.  Therefor, it seems if mobile banking has largely replaced collegial, organised and managed rotating credit associations.  It frees participants of the interpersonal tensions that often seem to build up in rotating credit associations (Aryeetey & Steel, 1996).  Mobile bankers offer considerable convenience, for example, for a trader who must tend a stall in a market place during hours when formal banks operate (Miracle et al., 1980).  In this way the transaction costs of clients are greatly reduced (Von Pischke, 1996).


In Ghana, informal mobile bankers are called susu collectors (note that the expression susu is used in Ghana for both ROSCAs and mobile banks).  They are well used by market women since these clients wish to obtain a lump-sum within the shortest period of time.  Through susu collectors clients can avoid delays at banks (Aryeetey, 1992a).  Periodically, savings collectors grant “advances” to some of their trust clients.  An average of 60 % of their clients request credit each month.  Collectors usually lend at the beginning of each month out of deposits mobilised in the first few days, in the hope that borrowers complete repayment within the month so that others depositors can receive the full value of their deposits.  Any outstanding loans on the last day of the month may prevent them from meeting their obligations (Aryeetey et al., 1997). 


Over 90 % of the loan applications that savings collectors receive come from clients that also save with these collectors (Aryeetey et al., 1997).  Access to loans proofed to be another major reason to use these informal collectors (Aryeetey, 1992a).


Miracle et al. (1980) did investigations in West Africa and found that mobile bankers are sometimes not from the same ethnic group as their customers and that they are commonly young men.  It is possible that many of them are mere agents for other individuals that are involved in financial business.  The latter is mostly economically powerful people.  They take advantage of the demand for financial services by those who are reluctant to use formal financial services.  Therefore Miracle et al. (1980) suggest that mobile banking is controlled by larger business people operating in the informal sector. Savings and Loan Companies


Since 1985, new forms of susu collectors emerged in Ghana in response to an increased demand for credit that stemmed from economic liberalisation and structural adjustment programmes.  They are called Savings and Loan Companies (SLCs).  Saver can be sure of being granted a loan.  These small companies operate on the same principles as susu collectors, and collectors are hired to take daily deposits (Aryeetey & Steel, 1996).  Instead of a deposit being returned to the saver after a month, the saver agree to have these held for at least five months by the company.  After this period, the savings may be withdrawn in addition to an equivalent amount of loan (Aryeetey, 1992a). 


The prospect of credit motivated a substantial number of people to put their savings in these institutions (Aryeetey & Steel, 1996).  Guaranteed credit disbursement depends on these companies' ability to mobilise new savings at any time.  Some SLCs fail to do so and, therefore, suffer from liquidity problems.  Hence, the difficulty of these companies to return deposits to savers resulted in discontented clients (Aryeetey, 1992a).  Aryeetey & Steel (1996) also report problems at the level of mismanagement of collected funds, excessive lending as well as a lack of adequate screening and monitoring in this system. Loan Brokers


Loan brokers facilitate contacts among people that have money to lend and borrowers by trading inside information about potential clients.  In contrast to most informal loans, these loans are usually larger and provided on longer terms.  Interest rates charged are usually high (Adams, 1989b).


These borrowers usually have no access to other lenders, e.g. formal lenders.  The service that the broker provides to the lender, is the provision of information regarding the potential borrower.  The loan broker is paid by the borrower for his effort to find a lender that is willing to engage in a transaction (Coetzee, 1992). Money Guards


Money guards are responsible persons who are willing to safeguard cash for individuals.  In essence, they offer a secure place to deposit funds.  Most often these savings do not generate any interest, although it is sometimes found that guards give depositors token favours or gifts.  Usually no restrictions are placed on the utilisation of the deposited funds by money guards.  The amount of money deposited by each depositor is normally small.  In some cases, depositors feel guards are doing them a favour by holding their money (Adams, 1989b). “Non-Financial” Financiers


The "middlemen" that operate between rural producers and for the greater part, urban consumers, often offer credit possibilities to producers.  These types of financiers include, among others, input suppliers, merchants, traders, millers and processors of agricultural commodities (Aryeetey, 1994).  Their financial arrangements are normally commodity-based and therefore, such loans link credit transactions with output sales or purchase of inputs (Germidis, 1990).  They will typically offer either supplier’s credit or an advance payment from a “middleman” against future purchases.  Middlemen do not ask for collateral but instead they enter into agreements with farmers, for example, to purchase all their farm produce over an agreed period.  However, these arrangements generate product prices that are invariably lower than market prices (Aryeetey, 1994).


This system can comprise an important source of credit for rural borrowers. They have a comparative advantage over financial institutions in lending to farmers because of stronger informational links that exist due to other business activities and relations with their rural clients.  Due to this additional involvement, lenders can effectively enforce repayment and incur lower transaction costs and risk (Esguerra, 1987). Landlords


Landlords are the most common lenders in land-based commercial arrangements.  They are especially found in Latin America (Germidis, 1990).  In fact, landlords can also be regarded as "non-financial" financiers.  In these arrangements mortgaging of tenancy or cultivation rights are used as collateral substitutes (Llanto, 1990).  By granting tenants’ loans, the landlord is ensured of labour and entrepreneurial skills, and also of the productive use of his land (Coetzee, 1992). 


According to Adams (1989b), the phenomena that landlords provide their tenants with loans, decreases, although some of them still do so.  Landlord lending is negatively correlated with land reform actions as well as with the expansion of other types of formal and informal finance.


In Tanzania, it was found that people that borrow from landlords are usually the same persons.  There are only a few, if any, new customers each year.  New borrowers were usually treated in a special way in the sense that they were given smaller loans of shorter duration and witnesses to the transaction were required (Temu & Hill, 1994). Partnership Firms


Examples of partnership firms are pawnbrokers, indigenous bankers and also a range of companies, including finance, investment, leasing, and hire-purchase companies.  Although many of these institutions do have a corporate structure with legal regulations on their activities, they are exempted, at least to a certain extent, from central bank controls and therefore included in the informal sector. Pawnbrokers


Pawning is one of the oldest forms of lending.  Pawnshops typically make small loans for short periods of time and require borrowers to exchange physical collateral for loans.  Unlike most informal financial arrangements, pawnbrokers usually have no information about their clients (Adams, 1989b).


The size of the loan is based on the value of the collateral that the client offers.  It tends to be less than the value of the article presented for collateral.  After loan repayment, the client receives the collateral back.  If he/she fails to repay the loan by due date, the pawnshop owner has the right to sell the collateral to redeem the loan (Coetzee, 1992).


There are great variations between countries in the extent to which pawnshops are regulated.  In some countries, pawnshops are even regarded as formal financial institutions (Ghate, 1990).


In India, it has been found that pawnbroking is a popular way to fulfil credit demands.  It supplies a multitude of small loans and therefore it finances a great range of credit requirements.  Loan requests are met instantly on points in time which are important in a rural household, e.g. prior to the planting season or with certain ceremonial activities (Jones, 1994).




5.1.2 Advantages and Disadvantages of the Informal Financial Sector


As already mentioned, the informal financial sector is of a very heterogeneous nature and shaped by the circumstances of the specific area.  Therefore, one should be very careful with generalisations (Aryeetey, 1992a).  Yet, there are several aspects that are common in most informal financial activities, while certain principles are found in several distinctive informal financial arrangements.  It will become clear from the following discussions. Advantages of Informal Finance Information


Informal lenders have inside information of their clients which enables them to sort doubtful borrowers and exert peer pressure to compel compliance to the loan contract (Llanto, 1990).  Information on the creditworthiness of potential borrowers can be easily obtained with minimal costs in comparison with FFIs.  Lenders usually live and work in the circumscribed area of their financial operations, which makes effective follow-up of outstanding loans possible (Germidis, 1990).  Therefore, moral hazard and adverse selection problems, which results from asymmetric information, are not as prominent in informal as in formal financial arrangements (Meyer & Nagarajan, 1991).  The importance and advantages of these informational links is well documented (Esguerra, 1987; Germidis, 1990; Meyer & Nagarajan, 1991).  It is most probably the biggest strength of informal finance.


A survey done on informal finance in Ghana revealed that 98 % of susu collectors responded that they do not lend to people they do not know, 60 % of those who borrow from moneylenders are recommended by old clients (Aryeetey, 1994).



Information is the core element of the application “screening” process.  Aryeetey (1994) states that screening is the most important component of the lending process for the informal sector.  In the case where groups are formed on basis of financial objectives “screening” of members are not based on whether they can pay back, but if they are committed to the group's goals.  Therefore, in the community or group-based arrangements, standard screening practises arise from group observations of the habits of individuals and group obligations towards applicants.  Aryeetey (1994) concludes that they do not screen loans, but membership, which totally depends on whether the person can be trusted to meet the obligations to the group routinely.  It is an effective disciplinary measure that the group exercises in the case of trouble.  A major criterion is the individual's character and how reliable he or she is. Loan application usually occurs verbally.


This stands in sharp contrast with banks which are normally only interested to know about the existence and extent of indebtedness.  Their standard screening practice is usually to visit the place where the project is to be conducted, before granting credit (Aryeetey, 1994).


Therefore, informal sources of credit in rural areas often demand no collateral.  Usually the main guarantee for repayment is an oral promise by the borrower.  Security on loans is contingent upon the borrower's past savings and credit record and on social pressure to abide certain rules of behaviour (Germidis, 1990). Personal Ties and Social Pressure


Financial transactions imply trust as measure of the level of confidence that lenders have in the borrowers ability and willingness to repay in the future.  Trust-building in informal finance appears to revolve around personal relationships.  Personal considerations seem to be a cardinal loan criterion.  Hence, proximity of friends and family reduces information and monitoring costs, kinship ties exert social pressure to repay and a well-established tradition of mutual help is considered as a social obligation (Bagachwa, 1995).  Bonds of mutual trust are usually build to assure future access to loans through reciprocity (Adams, 1989a).  Moreover, the ability to process valuable inside information leads to compelling contractual behaviour (Llanto, 1990). 


The group often satisfies more needs than just the financial needs of the individual member.  The social and other aspects as motives for groups’ existence have already been emphasised earlier.  Hence, each member is normally subjected to peer sanction and even eviction from the group (Bagachwa, 1995).  Termination of membership on account of a wilful breach of contract is thus besides being financially, also a socially costly, experience to defaulter (Llanto, 1990).  Therefore, most loans among relatives and friends do not require guarantees and collaterals.  Members also stick to their loan contracts in fear of being refused future loans in case of default (Bagachwa, 1995). Accessibility


Banks and other FFIs are normally found exclusively in urban areas, with few exceptions, while the majority of populations in developing countries lives in rural areas.  Access to informal finance is relatively easy for all sorts of clients in comparison to the formal sector.  It is due to, among others, IFIs' flexibility of operations to meet specific needs, clear and easy understandable rules and regulations, use of collateral substitutes, and rapid processing of requests and delivery of credit.  Loans can usually be obtained on short notice.  Hence, IFIs are willing to handle small amounts in both savings and loans (Bagachwa, 1995; Germidis, 1990).


Meyer & Nagarajan (1991) also comment on the accessibility of IFIs, which are used by the rich and the poor, but it is often the only source for the poor while it is an alternative source for the rich. Flexibility and Adaptability


IFIs can adjust to the specific needs of the transactors.  Informal loans are usually more ideal for rural borrowers concerning timing and use, in comparison to formal loans (Esguerra, 1987).  Moreover, IFIs are extremely responsive to their clients' economic and social requirements and characterised by local adaptability (Bagachwa, 1995).  Clients of formal intermediaries must normally subject themselves to the premises of the intermediary at times that may not be convenient to clients (Adams, 1989b).


Informal finance is usually open to new innovations and proposals from creative members.  These innovations may increase the efficiency of the specific system and make it even more tailor-made for its members.  Innovations in formal financial markets are often warped by regulations (Adams & Canavesi, 1989).


As already mentioned, different IFIs serve distinct niches of the informal financial market (Aryeetey, 1994).  Hence, a client's choice of what IFI to use also depends on circumstances.  Changes in the structures and functioning of IFIs usually reflect changes in the financial requirements of the members that, again, are a response to changes in the national economy. 


Ghana is just one example of many African economies which was subjected to high levels of inflation and severe shortages of basic consumer items between 1975 and 1988.  To save resources for future utilisation, under such circumstances, for any lengthy period may be an irrational act.  Consumers tended to hold as much of their wealth in liquid forms in order to buy scarce items that suddenly appeared on the market.  Hence, due to inflation, real income decreased and so the ability to withhold consumption in order to save becomes limited.  During this period, Ghana showed a decline in the prominence of ROSCAs, while interest in and support of individual susu collectors increased.  Since 1985, Ghana's inflation rate started to recover and, therefore, real incomes started to increase.  ROSCAs became more popular again.  Several of these organisations even showed new forms in response to the new economic setting.  For example, they lent pooled money at interest to members and non-members.  After repayments of these loans, each member that had contributed received his/her share plus interest back.  This again emphasises the inherent dynamism in indigenous systems (Aryeetey, 1992a).



Adams (1989b) also remarks how surprisingly quick informal finance can innovate new strategies to accommodate changes in the economic environment such as inflation, economic prosperity or recession.  It is ascribed to the flexibility and suppleness of informal finance.  It stands in sharp contrast to FFIs that are too rigid and brittle to respond effectively and in time to changes in the local farmers' situation or in overall economic conditions. Transaction Costs


Transaction costs are cut by informal finance in several ways:

·                  low overhead costs, because normally no facilities are being built or rented and no or low salary fees have to be paid;

·                  low loan processing costs, because of personal contact and collective experience creditworthiness of members can readily be assessed.  Activities are usually done with the minimal of paperwork;

·                  low loan recovering costs, due to better knowledge about prospective borrowers and due to community and kinship pressure that can be exerted once a loan is in arrears (Bagachwa, 1995).


Thus, transaction costs are cut for a great part due to a minimal of formal procedures and close proximity.  Interest rates are often more flexible in informal finance and therefore financial contracts can adjust more easily to differences in costs and risks (Meyer & Nagarajan, 1991).


According to Adams (1989b), transaction costs of informal finance are kept low by bringing financial services to places and at times that are convenient to clients.  Informal finance is usually transacted in clients’ homes, their neighbourhood, their work place, or where they shop (Adams, 1994).


Table 5.1.  Average values for variables in transaction costs of formal and informal sources of finance in South Africa (Coetzee, 1995)





Distance to source (km)



Number of visits to obtain a loan



Application time (days)



Form of pay-out



Cash (%)



Kind (%)



Interest rate (% per annum)



Deposit requested (%)



Size of loan (US$)





Aryeetey et al. (1997) did a study of both informal and formal financial markets in Ghana, Malawi, Nigeria and Tanzania during 1992 and 1993.  They found that informal methods yield loan administration costs that are significantly below those of banks, which were operating with much larger loans.  Banks had operating costs varying between 12 % to 19 % of amounts lent, while informal moneylenders and associations were mostly under 3 % (see also Appendix V.  Mean Loan Administration Costs: Formal vs. Informal Finance). Collateral Substitutes


Informal financial arrangements use non-conventional guarantees.  Less emphasis fall on material guarantees, which are usually used by commercial banks.  Procedures of informal finance are mostly characterised by a high level of social control (Debar & Van Lint, 1995).


Informal financial arrangements effectively use collateral substitutes.  It might involve:

·                  a tied contract where a borrower is compelled to sell his products to the trader lender at a price determined by the latter (Llanto, 1990; Zeller, 1994);

·                  impledge of cultivation rights to the lender for a specified period of time (Llanto, 1990);

·                  more favourable terms like lower interest rates and longer maturities for tested borrowers (Llanto, 1990);

·                  loss of future access to credit (Zeller, 1994);

·                  repayment of principle and interest in kind (Llanto, 1990);

·                  terms and conditions suited to the specific geographic location and the borrowers individual characteristics (Llanto, 1990; Meyer & Nagarajan, 1991).


According to Zeller (1994), the efficient use of collateral substitutes depends on the lender’s ability to obtain creditworthiness information about the borrower at low cost, which is the case for informal lenders. Loan Use


Informal lenders normally do not specify loan use.  Thus, the borrower is free to use the loan fund for whatever provides him higher returns or greater utility, e.g. to overcome periodic consumption shortage (Aryeetey, 1994; Bagachwa, 1995; Esguerra, 1987).  Furthermore, it lessens transaction cost (less paperwork to justify the loan) (Esguerra, 1987) and monitoring costs (Aryeetey, 1994). Loan Repayment


Not all informal loan contracts specify when the loan is to be fully repaid.  Many of these contracts are orally made, while some are incomplete or open-ended.  There is often an implicit understanding, especially with loans between relatives and friends, that the borrower will pay back when he/she is able to do so.  In other cases, an implicit understanding exists that the loan period is fluid and subjected to renegotiations under changing conditions (Adams, 1994).


Aside from loans among family and friends, most informal financial contracts include specifications about the form and what point of time loan repayments is to be made.  Loan specifications refer to whether loans are being disbursed in cash or in kind, and if repayment has to be done through money, products or services.  A silencer on the advantageousness of informal loan repayment is that in some societies debt obligations are inheritable, which means that if a father dies, his unpaid dept is passed on to his children (Adams, 1994).


Notwithstanding this, loan repayment rates are much higher at informal than at formal credit in LDCs (Llanto, 1990).  This is due to factors explained above, e.g. peer pressure, better information that helps to overcome moral hazard and adverse selection, flexibility regarding loan terms, etc.


 Aryeetey et al. (1997) conducted a survey in Ghana and Nigeria.  It revealed that at least 80 % of informal agents reported no delinquent borrowers, and all expected virtually 100 % repayment within three months of the due date.



Adams & Vogel (1990) point out that borrowers’ motivation to repay loans is strongly influenced by a belief in the timely availability of subsequent funds.  Moreover, it is often found in informal finance that loan repayment is the key to new loans.  This is a strong incentive to repay.  In other words, loan repayment guarantees financial access and security in the future to a significant extent (Debar & Van Lint, 1995).




Together, all these factors give the informal lender the edge over banks.  This results in a myriad of contracts between informal financial agents and rural clients, which are designed and adopted to the idiosyncrasies of the locality and the characteristics of the clients.  It is doubtful whether formal institutions, like state-owned banks, can as efficiently produce the same valuable, inside information that informal lenders posses and whether they can, at the same time, keep transaction costs low enough to give them a competitive alternative (Llanto, 1990). Disadvantages of Informal Finance Segmentation, Fragmentation and Dualism

 (See also section 4.4.6)


Formal and informal sectors face great difference in their relative prices and are characterised by barriers against flow between them, therefore it leads to dualism in the financial economy of the country (Ghate, 1990).  Coetzee (1992) also reports that fragmented markets and lack of integration of financial markets in most LDCs have not been positively influenced by informal activities.


Moreover, interactions within the informal sector are seldom observed because of the strict nature of its operations (Aryeetey et al., 1997). The principal limitation of informal agents is that they tend to operate on only one side of the market or within a circumscribed group.  Savings collectors' funds come entirely from their clients, while moneylenders use their own funds and do not borrow to increase their loanable funds, even though many of them are creditworthy.  ROSCA members have access only to the group’s savings.  Intermediation in terms of savings mobilisation and transmitting them to borrowers in other groups is limited.  The isolated, personalised nature of informal finance can provide substantial monopoly power, especially if the legal framework restricts moneylending.  It results in great differences in interest rates across different segments of the financial sector (Aryeetey et al., 1997).


Gonzalez-Vega (personal notification, 1997*) argues that informal financial transactions are mostly competitive only among agents who are in close “proximity”, i.e. in small market segments.  Outside the local boundaries, these financial services are prohibitively expensive, especially due to high information costs to screen and monitor borrowers.  Informal finance is seldom seen among agents who are far away from each other.  Thus, informal financial arrangements have difficulties to operate over long distances (Cuevas, 1989) and therefore activities take place in small geographic areas with limited links between these areas (Coetzee, 1992).


Llanto (1990) also states that informal finance is usually very group and location specific.  Although this is an advantage in the sense that it is shaped by the demands and social structure of the local people, it makes successful schemes hard to transfer to other communities.  Even within a country there are differences between ethnic groups, which make a financial system that is successful for one group, often unsuitable without adaptation for another group (Zeller et al., 1994). 


Fragmentation among informal financial units result in significant variation in transaction costs between them.  However, there is no indication that these come primarily from different screening, monitoring and contract enforcement practices.  Differences in transaction costs rather originate from the type of  “infrastructure” used by the units.  It varies particularly by personnel costs and extent of record keeping and stationary use (Aryeetey, 1994).


Competition among informal lenders in the same informal financial segments is limited between those who have access to the same “screening technology”.  For example, a lender that is not involved in trading, can not offer tied output as a suitable collateral substitute to potential borrowers (Esguerra & Meyer, 1989). 


According to Miracle et al. (1980), savings and loans groups are reluctant to make loans to individuals not known to at least part of the group.  Specialisation, which results from the high information efficiency in IFIs, may provide efficient services, but also limits access to new clients (Meyer & Nagarajan, 1991).  Likewise, Esguerra & Meyer (1989) conclude from a survey done in the Philippines, that a long-term relation between a lender and his borrowing clientele is a potential barrier for the entry of new lenders who might contribute to a greater volume of lending and lower interest rates, e.g. formal finance.


Balkenhol & Gueye (1994) doubt if tontines can and/or want to grow, due to the required mutual acquaintance criterion.  The closed character that many tontines have stems from the fact that members do not wish their families and friends to know that they have come into the possession of a cycle.  This has been labelled the “illiquidity preference”.  Hence, it is argued that with increasing numbers of members the risk of not being able to benefit from one’s turn, increases.


The heterogeneity and flexibility of informal financial arrangements make it difficult to quantitatively model informal finance.  There are a wide variety of informal financial institutional forms, moreover, within any one type, a variety of financial contracts between savers and borrowers exists.  It is difficult to determine trends, e.g. growth and decline, of informal finance.  Therefore, standard policy making is a very complicated matter (Meyer & Nagarajan, 1991). Exploitation


Exorbitant interest rates are not unknown in informal finance.  In fact, critics usually refer to it as the major justification to condemn the informal financial sector.  Cases where lenders charge 10 percent per cent per day on loans are then used as examples.  Horror stories are often cited and generalised about moneylenders or merchants who extend loans to persons whom they expect will be unable to repay.  Other examples are landlords who tie their tenants to land through dept at the company store or merchants who link loans to repayment in kind through products that are grossly underpriced (Adams, 1989b).


Although these situations are not always the rule, or simply cited out of context, they are possible.  Yet, it becomes evident when the lender exercises a large measure of monopoly power (Adams, 1989b).  The share of monopoly profit in the interest rates is largely determined by the degree of competition prevailing in a particular market or in inter-linked markets, for example, where credit agreements are linked to transactions in other markets.  Hence, active competition between informal markets is often limited due to restricted information flows among participants (Aryeetey et al., 1997).


These indictments ignore the endless number of informal loans made and repaid, some of which required only modest lending costs and often even no collateral.  In fact, a large number of borrowers who pay high interest rates on loans have the incentive to do so, due to investment possibilities that offer higher rates of return.  Inflation is also often ignored (Adams, 1989b). 


Ibe (1990) argues that whenever communities are able and willing to form voluntary self-help organisations, the reliance of individuals on professional moneylenders will be low.  This competitive situation makes it difficult for moneylenders to charge exorbitant rates on their loans.


However, unjustifiable exploitation does occur.  Pledging of collaterals that are worth several times the loan is a good example.  It may happen that the borrower loses use rights of the collateral pledge through pawning.  Examples are borrowing at some pawnshops in Sri Lanka, pawning use of cocoa trees in Ghana, or pawning paddy land in Thailand (McLeod, 1994).


Even in indigenous systems there is evidence of exploitation.  Bouman (1994) refers to the Ogbo system, a hybrid between ROSCA and ASCRA with a long history (unfortunately the author does not say how long), where too much power is placed in the hands of a few headmen, thus abusing their privileges.


Adams (1989b) concludes that there are three questions when one wants to know if lenders are taking undue advantage of borrowers.

1.  What are the risk involved in lending and what are the lender's opportunity costs?

2.  Are most informal lenders in a monopoly position in order to charge exorbitant profits?

3.  Are credit transactions linked with marketing and production to enhance exploitation by lenders? Small Amounts on Short Term


In informal finance it are rather small amounts that change hands, whether we are talking about saving or borrowing (Coetzee, 1992).  It does not function well with large amounts of funds (Cuevas, 1989).  According to Christensen (1993), informal finance is superior to formal finance regarding transaction costs only when transactions are kept to a small scale.  Therefore, informal finance is seldom suited to provide in the medium and long-term credit needs of their clients (Aryeetey, 1992a; Cuevas, 1989).  De Jong & Kleiterp (1991) confirm that long-term credit in the informal sector hardly exists.  It limits the economic development dimension of this sector to a great extent.  It implies that the added value of a loan is generally limited.


Currently, poorer rural households usually have a high demand for liquidity, especially before a sowing period or a harvest, or to cover running costs.  There is a demand for short- term credit that has direct positive effects on income.  This contributes to the popularity of informal finance.  However, Aryeetey et al. (1997) point out that many informal financial agents are unable to satisfy demand for loans by clients they considered creditworthy.  Moreover, as an enterprise develops through changes in products and forms of production and as there is an increase in market orientation, an increase in demand for long-term loans can be expected.  Thus, as the level of development rises there will be an increase in the demand for more fixed capital in order to invest in, e.g. more sophisticated machinery.  Informal finance might then not be able to meet the populations’ financial needs (Schmidt & Kropp, 1987). Co-Variant Situations


Informal security social networks at grassroot level are seriously weakened in the case of price shocks, as well as in times of natural catastrophes, e.g. droughts.  The effectiveness of these community networks is diminished by co-variate risk factors.  It is aggravated by the coincidence of seasonal credit needs for food and agricultural inputs at the beginning of the rainy season (Zeller et al., 1994).


Coetzee (1992) also points out that informal finance is often incapable to handle co-variant risk situations. The total demand for financial support in such a period can not be satisfied from local mobilised resources.




Thus, informal finance is not adequate to reallocate purchasing power throughout a country’s national economy, which makes it difficult to increase the productivity of available resources.  Moreover, informal finance’s negative consequences are hard to control and it does not meet the existing financial demand.  Hence, in order to stimulate economic growth, formal finance is needed.


5.2 Semi-Formal Finance


Semi-informal finance is usually not subjected to governmental registration or supervision, although rules of functioning may be laid down by law (Germidis, 1990).  It falls outside the purview of the formal banking authorities (Coetzee, 1992).  However, they are not a spontaneously result of local and/or traditional structures.  They rather have a "foreign" origin.  Still, they are mostly in the form of self-help groups and are often owned by their members. 


Key entities in semi-formal finance are (1) co-operatives and credit unions, and (2) Non governmental organisations.


5.2.1 Co-operatives Institutions and Credit Unions


Co-operatives and credit unions can be treated together because of similarities in their operational goals, and lending and savings characteristics.  Whereas co-operative movements deal mainly with agricultural and rural schemes, credit unions tend to be more urban orientated (Aryeetey, 1992a).  According to Aryeetey et al. (1997), rural co-operatives are more informal in their operations when compared to credit unions.  This study concentrates on rural finance, therefore more attention will be given to co-operatives. 


The Concise Oxford Dictionary (1990) defines co-operative as “a farm, a shop, or other business, or society owning such a business, owned and run jointly by its members, with profits shared among them.”


From a wide spectrum of co-operative financial institutions, there are two basic forms:

(a)    multi-purpose co-operatives whose main activities lie in the areas of product procurement and marketing, but which have a loan and/or savings component; and

(b)    rural savings and loan associations which provide their members with rudimentary financial services (Schmidt & Kropp, 1987).


Schmidt & Kropp (1987) state that at least one principle is common to all co-operatives: members are both clients and owners and they are normally organised along a grass-root democracy philosophy.

In the last few decades co-operatives have been an important source of farm credit, especially for small farmers.  Many governments have relied heavily on co-operatives to reach small farmers (Argyle, 1983).


Not all co-operative financial institutions conform to the ideal (Schmidt & Kropp, 1987).  Co-operatives were often intended to spearhead a process of rural transformation.  Yet, success stories are not so abundant as was hoped for.  In fact, there was an abundance of unsatisfactory results in comparison with the postulated outcome (Adera, 1995).  Many co-operatives in Third World countries are not firmly established institutions that are rooted in local, traditional behavioural forms and norms.  They are most often imitations of models from developed countries that have been introduced by foreigners.  Co-operatives occasionally fail because of the conflict between traditional authority structures and their more modern principles of grass-roots democracy (Schmidt & Kropp, 1987).  Argyle (1983) also points out that despite the potential advantages of such a system, building efficient co-operatives capable of handling credit has proved difficult in many countries.


However, government intervention may be the most important problem.  Co-operatives often become the enforcement channels of government policies, which seriously damage their stability, efficiency and the autonomy of these institutions (Schmidt & Kropp, 1987).  They are often linked to the national agricultural development bank or the central bank (Argyle, 1983).  Failure has been a common denominator under military, civilian, capitalist and socialist governments (Adera, 1995).  This is especially true where co-operatives are established as a cloak for government intervention regarding taxation of agricultural products, or if these institutions were used to enforce production increase (Schmidt & Kropp, 1987).


Many co-operatives tend to reinforce existing dualistic local structures or even aggravate class division rather than act as vehicles of equitable change (Adera, 1995).


5.2.2 Non-Governmental Organisations (NGOs)


Semi-formal operations often have a high involvement of non-government organisations (NGOs) (Coetzee, 1992).  In contrast with most FFIs, NGOs are interested in, and therefore, developed the ability to reach and serve the poor and the rural sector (Nwanna, 1994).  Schmidt & Zeitinger (1995) also describe NGOs in general as “motivated” and “dynamic”.  They work under most difficult circumstances, where governments and other institutional donors fail to reach people in need due to a lack of capacity (Abugre, 1994).  That is why, at the end of the 1980s, an enthusiastic believe in the potential of NGOs and their role in development flared up.


There is a great diversity in the number, growth rate, and activities of NGOs among LDCs.  Besides financial activities they also provide a range of other services including disaster relief and rehabilitation assistance, as well as other developmental programmes in connection with communication, construction, water, education, health, non-food relief, women's activities, etc. (Larson et al., 1994).  In fact, generally spoken, NGOs’ policy has undergone a major shift in emphasises during the past two decades.  Initially their policies were mainly welfare and relief orientated, but nowadays their policies seem to centre more around income generation (Bouman & Hospes, 1994).


In almost every LDC, financial services are provided by some active NGOs.  Besides financing income-generating activities, most of them are primarily involved in providing short-term, seasonal credit to farmers and microenterprises.  A large number of NGOs, however, do not have enough financial resources to meet the needs of their target groups.  NGOs tend to be small and poorly funded, often depending on assistance from abroad.  With a few exceptions, most of their activities are limited to resource allocation (Nwanna, 1994).  There are rarely NGOs found that can survive without heavy subsidies and grants from donors (Bouman & Hospes, 1994). 



6.1 Introduction


According to Abugre (1994), donor agencies must avoid to introduce new financial systems hurriedly.  Setting up new organisations is a money- and time-consuming process, while experience proofs that the chances of success are rather few.  Using and strengthening existing structures might be more feasible (De Jong & Kleiterp, 1991).  In several cases, existing informal systems are more appropriate, more adaptable and provide more insurance in comparison with any new or formal system, especially in crisis and turbulent situations (Jones, 1994). 


Flexibility and adaptability is required from financial services and their arrangements in situations of change.  This is especially true, because change is a discontinuous and turbulent phenomenon.  In such circumstances it would be unwise to interfere with informal financial systems that are adapted to the specific local conditions (Abugre, 1994).  Indigenous finance has its own sophisticated culture.  It can not easily be diminished or replaced by formal financial institutions or authorities (Jones, 1994).  However, informal finance alone is insufficient to meet all financial demands, leave alone to make a country international financially competitive.  A country can only develop to its highest financial potential through formal finance. 


Leaving both formal and informal finance for what they are, will not help to overcome the duality of national economies (Abugre, 1994).  Dualism and fragmentation inhibit development due to the fact that potential household savings go untapped and profitable investments cannot be financed (Aryeetey et al., 1997).  The only solution to overcome financial dualism is through integration and interlinkage between the formal and informal financial sectors.  Germidis (1990) defines integration as "transforming the formal sector and substituting it for the informal sector” and interlinkage as "preserving and using to advantage those characteristics of the informal sector which constitute its strength".  These two processes are sequential: linkage in the short term will bring integration in the long term.  In other words, until the formal sector can cover the country's financial needs on its own, the informal sector could be used to do part of the job and, for example, “retail” formal credit to its clients.


Informal finance has a great influence in resource allocation of rural households and micro-enterprises, but many of them are unable to meet the financial needs of their clients.  The resources available to the informal sector are too limited, especially on the long term.  In addition, access to formal financial institutions remains considerably limited, which means that a substantial number of loan requests by rural households and small businesses remain unmet (Nwanna, 1994). 


However, the formal sector in LDC, just like the informal sector, is often also constrained by a lack of long term resources.  LDCs are mainly dependent on foreign aid to fill this gap.  Therefore, foreign aid has to be linked with informal finance as well (De Jong & Kleiterp, 1991).


6.2 Competition or Complementation


Many financial strategies of the past (see Appendix III) aimed to displace the informal financial sector.  There is little evidence that this has succeeded.  The formal financial sector showed significant growth in LDCs, but the extent of gain that they brought to national incomes is disappointing.  Where formal finance is constrained, informal finance will usually find ways around these constraints (McLeod, 1994).  Gonzalez-Vega (1997, personal notification*) believes that informal finance will never disappear although its role may become less important as formal finance develops more.  However, formal finance needs informal finance in order to grow.  Therefore, informal finance must get its rightful place in a national economy.


Despite of the clear dualism that exists between formal and informal financial sectors in developing countries, they do not function independently from one another.  An expansion of the formal sector often results in a corresponding expansion in the informal sector.  Likewise, a contraction of the formal sector often leads to a contraction of the informal financial sector (Adera, 1995). 


In Thailand, 1983, the contraction of bank credit not only increased the demand for ROSCAs, it also decreased the flow of credit to ROSCAs (Adera, 1995). 



Some IFFs have strong links to formal finance, while others operate completely outside the formal system. Therefore, two motivations can be differentiated for the existence of informal finance: (1) informal finance as an autonomous system; and (2) informal finance exists as a reaction to the formal financial sector (Coetzee, 1992; Meyer & Nagarajan, 1991).  How significant linkages between formal and informal finance are for the development of the entire financial sector of the economy depends for a great part on whether the relationship between the two sectors is mainly complementary or competitive (Ghate, 1990).


The formal and informal financial sectors can be seen as a continuum of sub-markets arranged in declining order of degree of requirements met by the formal sector.  Each sub-market consists of a complex of inter-related variables, which include borrowing purpose, loan size, loan duration, the borrowers’ income and asset position, etc.  Figure 6.1 represents this model.


The left end consists of sub-markets whose needs are entirely met by the formal sector.  The segment to the right is totally catered to by the informal sector.  The reasons why certain financial clients belong to a particular sub-market are discussed in chapter 4 and 5.  In between the formal and informal ends is a range of sub-markets where the demand for financial services is fulfilled by both the formal and the informal sectors (Ghate, 1990). 


In their respective areas (A and B in figure 6.1), the two financial sectors have comparative advantages, and they are therefore complementary.  For example, a certain borrower may not be able to satisfy the requisites of the formal sector, such as a required collateral.  He therefore turns to the informal sector.  Here, he can acquire the loan on the basis of first hand information, or collateral substitutes, such as the inter-linkage of credit with marketing, employment or leasing transactions.  On the other hand, the formal sector may not offer the financial product that the borrower is looking for, e.g. consumption loans (Ghate, 1990).  Coetzee (1992) gives the example where FFIs do not serve remote areas, and therefore, the informal financial services that are provided there are complementary to the formal sector.


                                      Formal sector                              Both sectors                         Informal sector










A = Sub-market catered to entirely by formal sector, e.g. long term loans for fixed

                   investments in large industry.

            B = Sub-market catered to entirely by informal sector, e.g. small short-term loans to

                   poor borrowers with no collateral.

C = Sub-market catered to by both formal and informal sector, e.g. crop loans or

working capital for small enterprises


Figure 6.1 Sub-markets, arranged in declining order of financial needs provided by the formal financial sector (Ghate, 1990)



A lack of competition has unfavourable implications.  Borrowers can not freely negotiate on the formal and informal credit markets for the best terms and conditions.  This hinders them to improve their welfare (Chipeta & Mkandawire, 1992b).


In the middle segment, complementary relationships between the two sectors are also found. In other words, growth in demand in one sector is not at the expense of the other (Aryeetey, 1992b).  In this situation, they usually both grow together in absolute sizes.  For example, some sub-markets turn to the formal sector for their long-term financial needs, i.e. fixed investments, while working capital is borrowed from the informal sector.  Thus, as the supply of formal credit increases for one purpose, fixed investment, the demand for informal credit increases for the complementary purpose, i.e. working capital (Ghate, 1990). 


Aryeetey (1992b) gives another example of a possible complementary relationship, although it is seldom the case in reality.  If growth in investment possibilities, which usually relies on formal credit, increases, and if this additional capacity can only be met by informal credit, the application of the two types of credit may be regarded as complementary.  Thus, the informal sector plays a role as provider of residual finance.  The net impact that the two sectors will have on the national economy will depend on the volume of residual financing done by the informal sector in relation to total financing requirements.  Residual finance can be seen as additional finance available to investors in excess of what is offered by the formal sector.  Therefore, increased demand for informal credit is the result of a growing use of formal credit, due to a growing economy. 


Nevertheless, formal and informal finance may also compete with one another.  These financial demands occupy the middle segment, C, in figure 6.1.  In such a case the availability and terms on which financial services of the two types are available will determine the choice of sectoral source.  If there is improvement in one sector, one could expect clients to switch from the other source to this one.  Thus, the quantity of credit in a particular informal sub-market is the difference between the total demand for loans of that type, and that part of total demand supplied by the formal sector.  As formal loans of this type become more easily available on more favourable terms than those in the informal market, formal loans will displace informal loans (Ghate, 1990).  Likewise, financial sector repression, as was the case in Mozambique, causes many market participants to move to the informal sector because the formal sector ceases to provide satisfactory services (Larson et al., 1994).


However, this model is too simple to illustrate the real situation.  Other factors are usually related to informal finance, such as social ties.  Thus, informal finance offers another product than formal finance does.  Therefore, clients of informal finance may be willing to pay a higher price for a financial aspect, e.g. a loan of a certain amount, in the informal sector than at FFIs.  This reflects additional satisfaction that clients receive from informal arrangements (Adams, 1994).


McLeod (1994) argues that formal finance should complement informal finance, except if it is better able to compete.  As an economy evolves, individual incomes rise and medium and large-scale business activities begin to proliferate.  Therefore, a demand for all sorts of financial services appears, which creates opportunities for establishing specialised FFI.  Nevertheless, pre-existing demands for low-income households and small-scale businesses remain.  New FFI might still not be able to serve this demand better than existing informal arrangements.  Banks should simply be doing that what they are good at doing.  Aryeetey (1992a) confirms that the informal sector could play an effective complementary role to services offered by established FFIs and new innovative credit schemes.


Thus, integration can only be achieved if various segments are linked in such a way that they complement each other on those aspects where they have comparative advantage, while having access to the resource base of the entire financial market as a result of functional linkages.  If various segments fail to complement each other in the delivery of financial services, unrelated niches develop, which implies that large sections of the real economy are left with inadequate financial services.  Such considerable gaps in financial services are detrimental for overall financial sector development (Aryeetey et al., 1997).


6.3 Justifications to Enhance Linkages 


6.3.1 Advantages for Formal Finance


The number of rural borrowers can easily overwhelm formal finance, e.g. banks.   Many of them are small farmers applying for relative small loans without collateral and subjected to the risky nature of agriculture.  It results in transaction costs beyond price for the formal intermediary.  A major part to these costs results from asymmetric information (Llanto, 1990).


Informal financial agents and self-help groups possess a lot of valuable information and create precious avenues to bank credit and services (Llanto, 1990; Zeller et al., 1994).  The specificity of information and IFIs’ particular rules of exchange that assure contractual behaviour within the group are the informal sector's greatest asset.  They can internalise the costs of acquiring and generating information and use this information to tap bank resources (Llanto, 1990).  Zeller et al. (1994) report that the problem of information asymmetry, which leads to adverse selection and moral hazard, could be addressed by a linking-approach.  Indigenous, social cohesive village groups that traditionally perform coinsurance functions to their members, may be employed as a screening device for causes of defaults. Thus, if informal groups are linked with FFIs, two costs of the latter are shifted to the borrowers: (1) borrower screening costs, and (2) monitoring costs thus reducing transaction costs and repayment problems (Nagarajan et al., 1994). 


Interlinking financial market implies, therefore, that the formal sector can build on mutual trust developed over time and the operation of effective sanctions against deviant behaviour (Llanto, 1990).


FFIs tend to neglect rural savings, mainly due to the high transaction costs that result from numerous small amounts.  In contrast, several IFIs are recognised by an effective savings mobilisation performance.  Setting a link between these formal and informal financial institutions may imply that many deposits that would otherwise have remained outside the banking system, could end up with FFIs.  This additional savings mobilisation could be done through a relative inexpensive way in comparison of the costs FFIs would have incurred to mobilise these savings on their own (Aryeetey et al., 1997).


6.3.2 Advantages for Informal Finance


Rural people are reluctant to accept formal finance, because of their adherence to traditional practices, which have served their saving and borrowing needs for a long time (Temu & Hill, 1994).  Linking formal and informal finance might be the answer in that these people enjoy the benefits of formal finance in their own familiar environment.


A linkage system brings valuable information about the bank, the services it offers, the bank's own "rules of the game" and much more about banking technology to people at grassroot levels (Llanto, 1990).


Informal social security networks at grassroot level are seriously weakened in the case of price shocks, as well as in times of natural catastrophes, e.g. droughts and floods.  The effectiveness of these community networks is limited by co-variate risk factors.  It is further aggravated by the coincidence of seasonal credit needs for inputs at the beginning of the planting season (Zeller et al., 1994).  These problems could be overcome if the IFIs have access to the stronger financial base of the formal sector.


Moreover, the financial base of informal financial activity could be broadened to a larger membership than could be handled by ROSCAs or money keepers, if more formal financial institutions like co-operatives and credit unions could build on the existing informal system (Spio, 1994). 


6.3.3 In General 


The options available for the promotion of new foreign concepts to the rural poor have been limited in the sense that rural habitants have grown sceptical of government credit institutions and promotion offers, e.g. cheap inputs.  On the other hand, they still expect to receive new subsidies, which is incompatible with the long-term sustainability objective (Schmidt & Kropp, 1987).


According to Nwanna (1994), increased IFI access to formal financial market credit may lower the costs of funds to both parties and may reduce interest rates charges on their loans.  Thus, the cost of lending/borrowing will be lowered for both the lender and the ultimate borrower.  It may result in economies of scale, as well as greater competition in the delivery of services to rural clients, and therefore lead to deepening of the financial system. 


The major reason to link formal and informal finance is to enhance the integration between rural and urban financial systems (Zeller et al., 1994).  Spio (1994) argues that linking formal and informal financial markets may trigger a potential advantageous snowball effect.  A broader base will at the same time enhance the integration of currently fragmented markets.  Financial intermediation will be allowed to spread across larger geographic areas and thereby link the financial part of villages and involve more savers and borrowers.  Such an expanded geographic area would provide a large source for savings mobilisation.  It implies that a much larger fund pool is created from which loans can be granted.  This, in turn, allows farmers to increase their dept capacity and to make larger investments that might yield higher returns (Arteetey et al., 1997).  Thus, financial intermediation and allocation of financial resources will be much more efficient, and, thereby, enhance rural development (Spio, 1994).


According to Aryeetey et al. (1997), the effects of interest rate liberalisation in the formal sector greatly depend on the linkages between the formal and informal sector.  Liberalisation can result in a substantial and abrupt shift of funds toward the formal sector, attracting funds away from the informal market.  If there are no effective linkages, access of small micro-enterprises, small holders and the poor to credit will be reduced and thereby detrimentally affect their future income stream.


6.4 Options and Strategies


The following section must not be seen as a menu from which one suggestion can be chosen in order to make a formal-informal link.  It is rather a rough sorting of experiences, case studies, principles, and other suggestions that can be useful when one wants to establish a link.  Therefore, some sub-sections may overlap.


6.4.1 Strengthening Existing Linkage


Many informal saving groups deposit their funds in banks, while a lot of informal credit originates in the formal sector (Adera, 1995).