Paying Attention to the Informal Lending Sector

Paying Attention to the Informal Lending Sector

By HarmonyMedia | Fungal focus | 30 Jun 2021


Informal lending typically involves a lender and borrower who live in relatively close proximity, either the same household, village or nearby municipalities. Informal lending refers to a broad range of activity, the only key feature is the lack of tie in to states financial/regulatory oversight framework. Informal lenders can take form as family members, close friends, private professionals, cooperative, pawn brokers, shareholders, or small groups. The interest, collateral types and repayment mechanisms varied between and within these groups. Geographical locations and local economies also influence the nature of agreements, for example, rural borrowers have different needs and potential collateral options than urban borrowers. 

 Informal lenders exhibit intimate informational capacity compared to traditional finance; essentially, engagement and expression of local culture provides a better understanding of risk. Enjoying close proximity to their relevant local economy, the lender operates in the same culture, sharing social networks or social agreements with the borrower. This cultural flexibility supports dynamic relationships that traditional finance could not allow. The use of unconventional collateral types highlights the point. For example, in an agricultural setting an individual has more use for collateral in the form of livestock, access to land, trees, machinery. Traditional lenders often can not access the value of these unconventional collateral types due to regulatory or corporate concerns. 

Similar to the informational advantage, informal lenders hold a unique position for emergency loans. For spontaneous events, furaurals, sickness, weddings, a borrower (in rural China) not be able to access formal funding, so informal lenders fill the void. Even with 0 interest, these sorts of loans help maintain relationships, a sort of liquidity, and fulfill a spontaneous need (Zhou, Li, and Hiroki Takeuchi). Different cultures, countries and regions vary on these habits and dynamics. Empirical data on these differences can be difficult to obtain.  

 According to a Us Financial Diaries study (survey based in the US) loans from friends and family is the second most common form of credit. These loans tend on the smaller side, 41% were between 1-100$, 36% were between 100-500$, 9% were between 500-1000$, 5% were between 1000-2000$, 5% were between 2000-5000$, 3% were between 5000-10,000$. Usually households leverage a variety of sources for credit often mixing informal and formal arrangements.

The reasons households or individuals pursue familial loans are varied. 55% of households that borrow from friends and family also owned a credit card. They appeared to prioritize the informal route due to convenience and repayment flexibility. Friends and family often do not charge interest. 

Since the 08 recession, small businesses have experienced a credit gap from traditional lenders. Especially seeking small loans (below 250k$, but most acute below 50K$), these businesses could not secure operation financing from traditional lenders. Online semi informal/semi formal lending operations can potentially help fill this gap, revitalizing job creation and business formation, however oversight and technological concerns remain (Karen Gordon Mills).

We can collect information regarding differences in informal lending due to class, cultural and regional differences, but ultimately we need to understand there is a wide variety of arrangements that people may desire and we should position ourselves to help serve the variety rather than force users into a framework we perceive as desirable.

Credit Unions, Banking Cooperatives

From 19th century Europe, Friedrich Wilhelm Raiffeisen is considered the founder of credit cooperatives. Cooperatives form their own goals and intentions, but broadly they help various enterprising activities in a specific region and/or trade. Historically these cooperatives benefit lower and middle class people who either distrust or are shut out of the formal financial infrastructure. Principles such as nonprofit structure, democracic ownership, and local self help embodied the motivations behind cooperatives. Cooperative banks aim to spur development, for the benefit of its constituents. 

Typical business structure of cooperative banks varies from nation to nation and region to region. However in general they operate similar to other banks, deposits fund loan issuance. Some also focus on management of an investment portfolio, broadly there is no real difference in these approaches as purchasing equity, financed by a deposit, is a loan of sorts to some business. Seeking interest and returns ultimately comes from successfully identifying future value and risk.

A marked difference in mainstream finance and cooperatives is found in the type of information they engage in rather than financial structures they employ. Cooperatives, with their local origin and governance, can deal in “soft” information to inform their lending activities, such as personal relationships, local economy knowledge (real estate, soils, ect) . Global international financial institutions generally cant compete in such small specific locales (although this is not always the case) due to higher risk from information asymmetry. (McKillop, Donal et al)

Chapter 7: The Economics of Informal Lending and Fairness Motive

Ali, Jasmine & Banks, Marcus & de Silva, Ashton. (2016). Lending to family & friends: an invisible phenomena. 10.13140/RG.2.2.32248.03842.

US Financial Studies (2014) ‘An Invisible Finance Sector: How Households Use Financial Tools Of Their Own Making’, US Financial Diaries, http://www.usfinancialdiaries.org/issue3-informal

Zhou, Li, and Hiroki Takeuchi. “Informal Lenders and Rural Finance in China: A Report from the Field.” Modern China, vol. 36, no. 3, 2010, pp. 302–328. JSTOR, www.jstor.org/stable/20721315. Accessed 19 Aug. 2020.

Credit Unions, Banking Cooperatives
McKillop, Donal et al. “Cooperative financial institutions: A review of the literature.” International Review of Financial Analysis vol. 71 (2020): 101520. doi:10.1016/j.irfa.2020.101520

Small businesses, credit access 

Karen Gordon Mills and Brayden McCarthy. Working Paper 17-042. 2016. Accessed 8/28/2020 The State of Small Business Lending: Innovation and Technology and the Implications for Regulation 




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HarmonyMedia
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