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January 2010

Can Informal Finance Substitute for Formal Finance?

Asli Demirgüç-Kunt's picture

A couple of years ago, at a meeting of World Bank financial sector experts, one of the Vice Presidents at the time challenged me by saying, “You always talk about the importance of the financial sector for development, and emphasize we need to prioritize financial sector reforms, but just look at China. It is doing very well without a well functioning financial system.”

This struck a chord. I had also recently seen an academic paper making more or less the same point, that China is one of the fastest-growing economies in the world despite weaknesses in its formal banking system. Of course there is a large literature on finance which shows that development of formal financial institutions is associated with faster growth and better resource allocation. It has also long been recognized that informal financial systems play a complementary role in developing countries, typically consisting of small, unsecured, short-term loans restricted to rural areas, agricultural contracts, households, individuals, or small entrepreneurial ventures.

There is even a direct parallel in developed countries called angel finance, where high-net-worth individuals—“angel investors”—provide initial funding to young firms with modest capital needs until they are able to receive more formal venture capital financing. But informal finance substituting for formal finance? Conventional wisdom has always been that this is not likely since informal monitoring and enforcement mechanisms are generally ill equipped for scaling up and meeting the needs of the higher end of the market. 

Life After the Crisis: Where Do We Go from Here?

Asli Demirgüç-Kunt's picture

There are many who argue that the financial crisis proved that we have been wrong about most of our policy recommendations in the financial sector. I am not one of them. For example, consider the renewed fascination with development banks. Given the reluctance of private institutions to lend more during the crisis, many countries used their public banks to expand credit. (But others without such institutions used other innovative ways to do this – such as the US Federal Reserve.) Should we then conclude that government ownership of banks is desirable? Similarly, the crisis was so intense that many governments ended up as large shareholders in their banking systems (which is turning out to be temporary, as expected). Does this mean developing countries should abandon their bank privatization programs? Others interpret the crisis as a vivid example of market failure and wonder if much more aggressive regulation is a good idea.

You may have guessed already that my answer to these questions is no. Research is seldom conclusive, but in the area of state ownership of banking the evidence is as overwhelming as it gets. When it comes to lending, it appears that the state banks are the best at lending to cronies. Government officials face conflicts of interest that go against efficient allocation of resources – such as securing their political bases and rewarding supporters. Overall, greater state ownership of banking is associated with less financial sector development, lower growth, lower productivity and even less stability – and it is more damaging at lower per capita income levels where there are typically fewer checks and balances. So it is no wonder that many countries embarked on privatization programs and ought to continue with them. Surely this is a difficult process – but there is again plenty of evidence that well-designed privatization can significantly increase bank performance.