Banks, Informal Money Lenders and Asymmetric Information

Credit markets in developing countries differ substantially from their counterparts in industrialized countries. The following chapter gives a short overview about the peculiarity of rural credit markets and assesses the theoretical implications of these peculiarities.

The structure of the financial system differs widely across developing countries, depending on historical and colonial legacies, government policies, the level of economic development and the structure of the economy. Despite these differences, however, some general observations about the characteristics of financial systems in LDCs can be made.2

The financial systems in developing countries are generally much less developed, having a much narrower range of institutions and instruments and being relatively smaller relative to the size of the economy. Most importantly, financial markets in developing countries are typically strongly dominated by the banking sector. Bond markets and stock markets are developed only rudimentarily (if at all) and the banking sector is usually dominated by a few large and often government owned banks. There typically is only limited competition between these banks and government interventions in credit markets are frequent despite of almost ubiquitous efforts of liberalizing the sector (see Mehran et al. 1998). Even in the absence of a formal banking sector, credit markets in one form or another appear to be omnipresent and exist even in the poorest and least developed regions of the world.

In fact, credit markets have a very important role in the functioning of an economy. At the most basic level, credit transactions serve to facilitate production through financing working capital and fixed capital investments. Typically in rural areas working capital is of the greatest importance and it is primarily used to buy agricultural inputs. Moreover, borrowing is also used for consumption purposes, for example to allow consumption before harvest or finance large expenditures such as weddings, funerals etc. Thereby, borrowing allows people to smooth consumption in face of fluctuations, especially when production is risky and insurance markets are incomplete.