Informal Finance: A Theory of Moneylenders

This study examines the co-existence of formal and informal finance in underdeveloped credit markets. Moral hazard at the investment stage prevents banks from extending funds. By contrast, the informal sector is able to monitor borrowers and induce investment by offering credit to a group of known clients.The paper provides a theory of informal finance that rationalizes credit market segmentation as well as multiple lending from banks and informal lenders. It suggests that market segmentation leads to higher informal interest rates with adverse welfare effects on borrowers, while multiple lending from both financial sectors induces lower informal interest and improves welfare.The study presents a model where the driving force is the interplay between the different constraints that formal and informal lenders face. Findings include:

• By ensuring prudent behavior, informal lenders are able to extend funds when banks cannot;
• Additional informal credit increases the investment of bank-rationed borrowers;
• By increasing investment return, it decreases borrowers' relative payoff following default, inducing banks to lend more liberally;
• By channeling bank capital, it reduces banks' agency costs from lending directly to borrowers, limiting banks' extension of borrower credit.