FORMAL AND INFORMAL SECTOR LOANS

FORMAL AND INFORMAL SECTOR LOANS

We have seen in the above examples that people obtain loans from various sources. The various types of loans can be conveniently grouped as formal sector loans and informal sector loans. Among the former are loans from banks and cooperatives. The informal lenders include moneylenders, traders, employers, relatives and friends, etc. In Graph 1 you can see the various sources of credit to rural households in India. Is more credit coming from the formal sector or the informal sector.

Graph 1: Sources of Credit per Rs 1000 of Rural Households in India in 2012

The Reserve Bank of India supervises the functioning of formal sources of loans. For instance, we have seen that the banks maintain a minimum cash balance out of the deposits they receive. The RBI monitors the banks in actually maintaining cash balance. Similarly, the RBI sees that the banks give loans not just to profit-making businesses and traders but also to small cultivators, small-scale industries, to small borrowers etc. Periodically, banks have to submit information to the RBI on how much they are lending, to whom, at what interest rate, etc.

There is no organisation which supervises the credit activities of lenders in the informal sector. They can lend at whatever interest rate they choose. There is no one to stop them from using unfair means to get their money back.

Compared to the formal lenders, most of the informal lenders charge much higher interest on loans. Thus, the cost to the borrower of informal loans is much higher.

Higher cost of borrowing means a larger part of the earnings of the borrowers is used to repay the loan. Hence, borrowers have less income left for themselves (as we saw for Shyamal in Sonpur). In certain cases, the high-interest rate for borrowing can mean that the amount to be repaid is greater than the income of the borrower. This could lead to increasing debt (as we saw for Rama in Sonpur) and a debt trap. Also, people who might wish to start an enterprise by borrowing may not do so because of the high cost of borrowing.

For these reasons, banks and cooperative societies need to lend more. This would lead to higher incomes and many people could then borrow cheaply for a variety of needs. They could grow crops, do business, set up small-scale industries etc. They could set up new industries or trade in goods. Cheap and affordable credit is crucial for the country’s development.

Source: This topic is taken from NCERT TEXTBOOK

FORMAL AND INFORMAL CREDIT: WHO GETS WHAT?

FORMAL AND INFORMAL CREDIT: WHO GETS WHAT?

Graph 2 shows the importance of formal and informal sources of credit for people in urban areas. The people are divided into four groups, from poor to rich, as shown in the figure. You can see that 85 percent of the loans taken by poor households in the urban areas are from informal sources. Compare this with the rich urban households. What do you find? Only 10 percent of their loans are from informal sources, while 90 percent are from formal sources. A similar pattern is also found in rural areas. The rich households are availing cheap credit from formal lenders whereas the poor households have to pay a large amount for borrowing.

Graph 2: Of all the loans taken by urban households, what percentage was formal, and what percentage was informal?

What does all this suggest? First, the formal sector still meets only about half of the total credit needs of rural people. The remaining credit needs are met from informal sources.

Figure:  A worker stitching a quilt

Most loans from informal lenders carry a very high-interest rate and do little to increase the income of the borrowers. Thus, it is necessary that banks and cooperatives increase their lending, particularly in rural areas, so that the dependence on informal sources of credit reduces.

Secondly, while formal sector loans need to expand, it is also necessary that everyone receives these loans. At present, it is the richer households who receive formal credit whereas the poor have to depend on informal sources. It is important that the formal credit is distributed more equally so that the poor can benefit from the cheaper loans.

Let’s work these out

1.  What are the differences between formal and informal sources of credit?

2.  Why should credit at reasonable rates be available for all?

3.  Should there be a supervisor, such as the Reserve Bank of India, that looks into the loan activities of informal lenders? Why would its task be quite difficult?

4.  Why do you think that the share of formal sector credit is higher for the richer households compared to the poorer households?

Source: This topic is taken from NCERT TEXTBOOK