Informal Finance and The Design of Microfinance

This paper examines the advantages and disadvantages of informal finance, and describes seven ways for microfinance to acquire the virtues of informal finance.

The advantages of informal finance include slashed transaction costs, supply loans, savings and insurance, substitution of confidence in character for physical collateral, socially enforced or self-enforced contracts and sequences of repeated transactions. Its disadvantages are that it has no deposit insurance, no large and/or long loans and no recourse to legal systems to enforce contracts. Microfinance can acquire the virtues of informal finance by:

• Not capping interest rates;
• Not outlawing informal finance;
• Allowing people to form their own joint-liability groups;
• Letting loan officers judge risk;
• Using collateral that is easy to repossess;
• Providing deposit services.

Informal finance has a lot to teach microfinance. Knowledge of the virtues of informal finance, however, does not imply knowledge of how to acquire those virtues. Policy advice must not only instruct microfinance organizations to imitate informal finance, but it must also say how to do so. SafeSave in Bangladesh is an example of how this might happen in practice.