A linkage of formal and informal financial sectors

„As long as the two markets (formal and informal) continue to be rigidly separated, the financial sector will be severely limited in its contribution to the transition from a static to a dynamic economy. In order to exploit the potentials of each sector and to optimize their contributions towards this transition, the two or the three sectors⁵⁴ have to be linked“

(KROPP/MARX/PRAMOD/QUINONES/SEIBEL 1989:31).

Several decades ago, various terms such as organized/unorganized and institutional/non institutional were used to define formal and informal finance. Further research has shown that many forms of informal finance are not only well organized but some of these are deeply entrenched social institutions. This led to the changes in terminology. The application of terms formal and informal have hinged on regulation by some central monetary state authority. If the financial transactions were subject to regulations, the terms formal was applied and all other financial transactions are termed as informal (WAI, 1992:338).55 As stated, formal finance means formal saving organizations or state operated saving organizations such as commercial banks, post offices, National Saving Organization (NSO) etc., while informal finance means self-help groups, small saving organizations based upon personal relations, rotatory saving groups, etc., within the context of the present study. On the average, informal finance comprises small and short-term transactions that are based upon personalized interactions; the arrangements are highly flexible, adapt to the economic changes, are innovative and involve low transaction and information costs because they reach the client. In contrast, formal finance usually handles larger and long-term transactions that are often quite impersonal, the transactions are complicated, involve a higher grade of bureaucratic procedures and a substantial amount of paper work; apart from this, transaction costs are usually high, because in most cases transactions take place in the office of the financial intermediary and clients have to reach it.

KROPP/MARX/PRAMOD/QUINONES/SEIBEL (1989:30-31) summarize the strengths and weaknesses of both sectors. In their opinion, each of the two sectors has its particular strengths: the formal sector excels in modernity, in access to national and international refinancing institutions and in access to other supporting institutions, none of which applies to the informal financial sector. The informal sector, on the other hand, excels in accessibility, popular participation, basic needs orientation, organizational flexibility, local adaptability, situational appropriateness and socio-cultural integration at the local or regional level, none of which applies to formal financial markets. Within the context of weaknesses, the formal sector comprises a powerful modern sector with the potential of contributing to the dynamic growth of the economy, but is limited to a few - and is therefore unable to initiate self-sustained development. The informal sector is open to all, but comprises a weak indigenous sector, contributing mainly to survival through self-help and to slow development on the local level.

54 Third sector means a financial intermediary between formal and informal sector which forms a ‘semi-formal sector.’ These activities may be partially regulated by a government agency through licensing or supervision. See also SEIBEL/PARHUISP (1992:239-248).

55 See, for instance, WAI (1992).

A number of policy implications are recommended by different authors⁵⁶ within the context of informal finance in different eras. The majority of them, however, is of the opinion that informal finance helps in improving the well-being of the poor. Some of them expect positive results in enhancing the performance of informal finance and learning from it rather than abolishing it. Others view the establishment of prudential regulations a proper means to organize a substantial amount of deposits. Many authors favor leaving it as it is.

Under this strategy the main consideration is to avoid policies that inadvertently and unfairly hinder it. Another strategy involves learning from it, but not attempting to alter its activities through outside interventions.

The establishment of a closer link between the two sectors can be well understood on the basis of two renowned rural development strategies:⁵⁷

'Top-down strategy,’ the basic theme of the strategy is to bring formal finance down to a lower level in order to establish a closer contact with informal finance that attempts to increase the access of self-help groups or informal lenders to banks. Several countries such as Indonesia (BOUMAN/MOLL 1992:209-224; SEIBEL/PARHUISP 1992:239-248), Sri Lanka and Malaysia (SANDERATNE 1992:85-102; BOUMANN/BASTIAANSSEN 1992:181-194)) are experimenting this strategy.

A second approach is the 'bottom-up strategy,' the basic theme of this approach is to help large informal groups in assembling sufficient funds to make a small informal bank-like organization, which may either be converted into a semi-formal or formal financial organization or may be linked with the formal sector through a mediator. The type of evolution in the former case has occurred in Cameroon (SCHRIEDER/CUEVAS 1992:43-56) and is also reported to have occurred in Japan.

Major constraints in the way of establishing such linkage with reference to rural areas of Pakistan can be:⁵⁸

– The difficulty in recognizing and understanding many financial transactions, which are financial in nature but are not manifest as financial. These are not some isolated phenomena, but occur rather as a part of a complex web of various relationships. For example, the complex arrangements of saving, investment, insurance and financing are difficult to differentiate.

– These interlinked transactions are based upon 'personalized interactions' and offer, therefore, a wider informal range of contracting possibilities. Such transactions usually involve the vested interests of both parties and usually result in some novel arrangements on a non-monetary basis. A financial transaction in such an atmosphere can be settled otherwise, instead of being repaid in cash. One may repay part of the debt in the form of labour or political loyalty, which makes the contract attractive for both sides. A formal sector cannot offer such alternative arrangements, since it is not a part of that complex web.

An attempt to convert informal into formal may be a danger for the stability of that informal group. If the knowledge of intragroup cohesion is incomplete and the extent of formalization is not controlled accordingly, such a link may cause the dissolution of the

56 See for instance, ADAMS (1992); SHIPTON (1992); SCHRIEDER AND CUEVAS (1992); GRAHAM (1992); SANDERATNE (1992); NAYAR (1992); BOUMAN AND MOLL (1992); HOSPES (1992);

SEIBEL AND PARHUISP (1992); WAI (1992); and ADAMS AND GHATE (1992).

57 See also MOORE (1953:139-159), SEIBEL AND PARHUISP (1992).

58 See, for further details on the topic, KROPP/SCHMIDT (1987).

informal group without establishing a link. SCHMIDT and KROPP (1987:98) mention the following risks in this connection:

– A higher degree of formalization may lead to more pronounced differences among the individual members, if, for example, some of them take the status of official.

– A preference for formal incentives regarding group needs may cause the group to dissolve. For example, despite an internal need for capital, the group’s savings are deposited with a formal organization in the expectation of receiving credit which is then not paid out after all. This can be considered as being against the group sincerity which is the actual logic of forming such self-help groups.

– In the case of conflicts about the distribution of loan or interest which may have been received and especially if repayment problems arise.

– In the case of mediation through a third party, new dependencies may be created if advisory services are not particularly competent. Most of the time, such mediators or the people working in such mediating entities also have their own personal interests and goals in mind, and these are not always the same as those of the savers.

The linkage model has two key dimensions⁵⁹:

an institutional linkage dimension, encompassing a link between rural households and banks through a non-governmental organization;

a financial linkage dimension, encompassing a link between savings and credit.

This can only be possible through a third agency such as⁶⁰

− private voluntary organizations,

− governmental organizations or

− special programs or projects, as intermediary.

The intermediation may be of the following three types:

− financial intermediation, with the intermediary acting as a depositing and lending agency, or

− consultative intermediation, with the intermediary acting as an advisory body assisting rural households to link with banks, or

− financial as well as consultative intermediation.

The special Savings/Joint Enterprises scheme of the Grameen Bank of Bangladesh may be mentioned as a most successful example of the above-mentioned financial linkage with an opportunity to move on from individual loans to joint enterprises. These special savings are voluntary and may vary from one to five taka (local currency) per member per week. If members of a center intent on starting a joint enterprise such as rice-husking mill or leasing a field for cultivating tobacco, they must first demonstrate that they can save money for that purpose. The Bank then supplements these funds with a loan. As a general

59 See also KROPP/MARX/PRAMOD/QUINONES/SEIBEL (1989:51).

60 A similar approach is mentioned by KROPP/MARX/PRAMOD/QUINONES/SEIBEL (1989:55).

rule, the Bank does not extend a loan more than ten times the amount of the member’s savings (YUNUS 1988:122).