Credit markets in developing countries can be divided into three broad categories:
Formal, Semi-formal, and Informal Credit. Formal credit encompasses what we
know to be conventional sources of credit such as large government and commercial
banks. They tend to require forms of collateral and be governed on a federal or state
level. Informal Credit encompasses individuals. They tend to use non-conventional
forms of collateral such as social collateral to monitor loans. Semi-formal Credit
includes sources that seemingly exhibit traits of both Formal and Informal Credit
such as microcredit or microfinance. Research has largely been focused on the
development of formal credit sources, but only recently has the focus shifted
towards the informal sector.
There are two leading views as to why formal and informal credit markets coexist.
The first is a policy-based explanation that government regulations on the formal
credit market have resulted in the resurgence of an informal credit sector1. The
argument is that in imposing regulations such as interest rate ceilings on the formal
sector the government actually limits the amount of lending that the formal market
is willing to extend to the poor as the low rates prove to be unsustainable2.
Borrowers then turn instead to informal sources of credit that are more accessible
and not restricted by government policies.
The alternative view is that information asymmetry exists for formal lenders
regarding the creditworthiness of individuals. The difference in costs of screening,
monitoring, and contract enforcement across lenders thus leads to fragmentation in
credit markets3. Borrowers then turn to informal sources of credit that do not
require conventional forms of collateral and use other means of monitoring