5.1 Informal credit market, asymmetric information and formal-informal
linkages
The literature on informal credit markets explains informality in the financial sector as
a cause of pre and/or post-contractual imperfect information which generates problems
of adverse selection and moral hazard. According to this literature, credit-constrained
individuals with limited access to formal banks try to borrow money informally.
5.1.1 Horizontal linkages
Within this framework, formal banks compete directly with informal moneylenders. In-
dividuals can access credit in a two tier process by first approaching formal banks with
excess liquidity, and then, as this is no longer available, move onto informal moneylenders
to borrow residual funds. Bell (1990) examines the impact on the rural credit market in
India of the introduction of a system of rural cooperatives in the 1950s. Indian data shows
that the creation of the rural cooperatives displaces the informal moneylenders. In an
analytical framework, Bell (1990) shows that such a trend arises because the monopolistic
market power of the rural moneylenders is curbed by the increased competition from the
formal credit institutions such as cooperatives, banks, and government.
Kochar (1997) investigates credit rationing constraints in rural credit markets in India
and particularly, separates the demand for credit from the lenders’s decision on access.
Kochar recognizes the fact that the provision of formal credit to rural farmers at a relatively
low interest rate in an attempt to expand agricultural investment may lead to an excess
demand for formal credit, and thus tougher formal credit rationing constraints. It is such
rationing constraints that impart a dual nature to the rural credit market: the formal
regulated sector and the informal sector. Both Bell (1990) and Kochar (1997) argue that
the rationing constraints such that lenders have to charge a high rate for risky households
due to the high screening and monitoring costs would limit the role of formal credit in
enhancing rural investment and reduces the demand for credit.
Arnott and Stiglitz (1991) investigate the theoretical underpinnings of insurance mar-
kets characterized by moral hazard, and show how moral hazard can have a mixed impact
of non-market insurance institutions. Households and firms borrow from friends, family
and neighbors when hit by an adverse shock, and pay back later when things get better, as
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