A Comparative Study between Informal and Formal Finance: A Literature Review

Abstract

The informal credit system is a prevailing form of economic exchange in emerging countries. It is the predominant form of credit in rural communities because it is based on a culture of reciprocity (Family participation-relatives-Loyalty-friends-Neighbour). Informal finance contributes significantly to the growth of small and medium-sized enterprises (SMEs). The present study justifies the wide application of informal finance. We find that these projects suffer from the problem of asymmetrical information. They also offer few guarantees. Informal financiers have an advantage over formal financial organizations, in gathering information on lenders in SMEs. The aim of our study was to explore formal and informal credit systems and to explain the prevalence of informal systems in developing countries. The study concluded that credit from informal sources is superior to credit from formal sources because it results in low rates of default on loans. The study also showed that informal finance and commercial credit have a positive impact on the performance of private companies, measured using the rate of return on assets.

Effect of Loan Management Practices on Non-Performing Loans for Deposit Taking Savings and Credit Cooperative Societies in Kenya

“…This theory indicates that formal lenders are prone to monitoring risks because they are not able to ensure that credit was used for the purpose applied for. However, informal finance providers do not have this reservation as they can screen borrowers and develop precise conditions for credit issuance (Abdelzaher, 2019). Whilst institutionalized lenders appear to have access to unlimited funds and resources for use as loanable funds, this inability to screen, monitor and follow up on borrowers exposes them to loan delinquency.…”

“…The major limitation of informal finance theory is drawn on its assumption that formal lenders are prone to more risk that informal lenders. Formal lending operates under a regulatory framework and credit protection is available to banks whereas this is not the case in informal finance (Abdelzaher, 2019). Moreover, assuming that interest rates in informal lending changes in line with demand and supply is elusive because interest may change from lender to lender in the informal credit market.…”