The financial sector of developing economies are characterized by the existence of formal and informal financial sectors. The formal financial sector refers to institutions like banks, thrifts, and industry banks. The informal financial sector refers to services like individual lending, commodity-based trading, and group savings schemes. While we understand that a formal financial sector can arise with economic development, why do informal financial sectors persist in developing countries when formal financial services are available?

The availability of information is central to financial markets. In the United States, for example, when we apply for loans, lenders have access to credit history to assess the borrower’s ability to repay. In developing countries, such information may simply not be available. For instance, in an economy where transactions are done primarily through cash, it’s not possible for a borrower to reveal or for a lender to discover credit history. In other words, developing countries have a particular problem with information asymmetry that is more acute than in developed countries. The ability to find information, therefore, determines what types of financial services will exist in an economy. Theoretically, firms that are more efficient at discovering reliable information are more likely to succeed in these economies.

For instance, Floro and Ray (1997) show that the informal financial sector in the Philippines is characterized by low competition that prevents the supply of credit from expanding. This oligopoly occurs because of conscious determination to collude and create barriers to entry for the market, such as through informal price agreements, monitoring, and threats. While strategic cooperation may indeed be occurring in the Philippines, asymmetric information may be a root cause to why the market allows for such behavior. The informal financial sector is in competition with itself and with the formal financial sector. Unlike the formal financial sector, the informal financial sector has the distinct advantage that the financier can also be a business partner. In this respect, the financier can exploit the information it has about the lender that was obtained simply by doing business with the borrower in the past.

For example, a miller can loan funds to the patty trader without knowing the trader’s formal credit history because the miller can assess the credibility of the patty trader directly from his own transaction experience. A bank, on the other hand, would not be able to engage with the patty trader because the bank does not have that strong business linkage. Similarly, the miller would not be able to provide a loan to a rancher because a stronger business linkage, such as a butcher, can more efficiently assess the credibility of the rancher. This type of market structure allows both the miller and the butcher to set loan terms above the competitive level because these financiers cannot compete with each other effectively.

This situation is problematic because consumers in developing countries are people who would benefit most from competitive loan terms. To address this problem, stronger linkages between the formal and informal financial sectors are advocated by Ghate (1992) and Aryeetey (2008). However, even in this realm information asymmetry prevents the linkages from occurring. While stronger competition between the informal and formal sectors would certainly improve loan terms (Ghate 1992), when the informal sector is more efficient at discovering information than the other sector, the informal sector will maintain a foothold in the market at the detriment of consumers.

Dealing with this problem requires setting a level playing field in both the formal and informal sectors. Formal processes of measuring creditworthiness can go a long way to making financial services more competitive in these economies. Access to technology that track consumers’ activities, such as expanding use of credit and debit cards, can also help make information more easily and cheaply available. As information becomes cheaper to obtain, we should see stronger competition among the formal and informal financial sectors.