The informal financial systems that operate outside the formal economy are not primitive alternatives to formal finance. They are rational responses to formal finance's failures.
What Informal Finance Does
Informal financial systems — the rotating savings and credit associations, the informal money lenders, the mobile money networks operating outside formal banking regulation, and the community solidarity mechanisms that provide insurance against economic shocks — serve the financial needs of the populations that formal financial systems do not reach. They provide access to credit, savings mechanisms, insurance, and payment services to people who are excluded from formal financial services by documentation requirements, collateral requirements, credit history requirements, and minimum transaction sizes that the formal system requires but that the populations informal finance serves cannot meet.
Informal finance is not a primitive alternative to formal finance. It is often a sophisticated response to specific failures of formal finance — the absence of services calibrated to the transaction sizes, the risk profiles, and the collateral structures that low-income populations present. The rotating savings and credit association provides the lump-sum savings accumulation that formal savings accounts cannot provide at the transaction sizes its members can afford. The informal moneylender provides the speed and flexibility that formal credit processes cannot provide in the time frames that agricultural or emergency credit needs require.
The Integration Challenge
Integrating informal financial services into the broader financial system — extending the consumer protections, the stability, and the interest rate competition that formal finance provides to the populations currently served only by informal finance — is one of the most consequential financial development challenges. It requires financial system design that is calibrated to the actual transaction sizes, risk profiles, and collateral structures of the populations to be served, rather than the extension of formal systems designed for different populations.
Informal finance is not the problem — it is the solution to the problem of formal finance's failure to serve everyone. The question is not how to eliminate informal finance but how to extend the formal system's protections to the populations that informal finance serves because the formal system will not.
Discussion