Vertical Links Between Formal and Informal Financial Institutions

What are the outcomes of inter-linkages between trader-lender and banking institutions?

This paper investigates vertical linkages between formal and informal financial institutions. Specifically, it studies a policy that expands formal credit to informal lenders, in the hope that this will improve loan terms for borrowers who are shut out of the formal sector.

The paper attempts to examine the efficacy of formal, informal linkages from the view point of informal borrowers. It further:

  • Analyzes linkage between trader-lender and banking institutions and its potential effects on allocative efficiency and welfare of small farmers;
  • Discusses two kind of interplay between formal and informal credit markets:
    • Vertical;
    • Horizontal.
  • Presents a brief overview of informal credit sector in the Philippines;
  • Highlights both market driven and government induced levels of interactions;
  • Presents a theoretical framework for understanding vertical credit links between formal and informal sectors.

The paper points out certain arguments against formal informal linkages:

  • Structure of formal credit is a major constrain in its ability to serve rural poor;
  • Formal and informal intermediaries apply different set of behavioral rules to deal with monitoring and enforcement issues; such linkages reduce informational asymmetries;
  • Expansion of formal credit might strengthen the ability of informal lenders to collide among themselves.

The paper concludes with the following:

  • There is a need for serious re-examination of the nature of market competition when horizontal network of information sharing is common between lenders;
  • There exists a necessity to study carefully the consequent outcomes of vertical relationships;
  • Effects of stronger vertical links depend on the form of lender competition;
  • If the relationship between lenders is one of strategic cooperation, an expansion of formal credit may worsen the terms faced by informal borrowers.

About this Publication

By Floro, M.S. & Ray, D.