Introduction: Linkages between formal and informal financial institutions

Access to a broad range of rural financial services can have a significant impact on people's ability to weather economic shocks, make investments and build up financial and physical assets. But, supplying financial services in rural areas continues to be a formidable endeavour. Faced with high costs and risks of doing business in harsh economic and physical environments, most financial institutions are reluctant to enter rural markets. In their absence informal financial institutions emerge, but typically they are only able to offer a narrow range of financial services in a small geographic area. Through strategic partnering formal and informal financial institutions are finding new ways of establishing a presence in rural markets. As the cases presented in this book reveal, strategic partnerships and alliances allow them to surmount many of the cost and risk obstacles that preclude them from expanding financial services at and beyond the rural market frontier. However, although conceptually valid, establishing and maintaining such linkages in practice may be harder than it looks.

In this book we examine eleven financial linkage cases from Africa, Asia and Latin America. The cases were funded by the Ford Foundation with additional contributions from the Food and Agriculture Organization (FAO) of the United Nations. Over a period of 18 months one country overview and 11 case studies were conducted from late 2004 to early 2006. The aim of the study was to evaluate the degree to which financial linkages increase the supply of a broad range of financial services, not just credit, in rural areas. We defined a 'financial linkage' as a mutually beneficial arrangement between formal (commercial, state, apex banks, etc) and semi and informal financial institutions (microfinance institutions, NGOs, credit cooperatives, village banks, self-help groups, etc.). The linkages were considered successful when based on market principles and resulting in sustainable expanded access to financial services for new segments of the rural population not traditionally served, broadening the variety of products and services already offered and/or creating quality improvements of current products through better terms and conditions.

The rationale for linking is based on the premise that natural complementarities exist between the formal and informal financial sectors that, when joined, reduce the costs and risks in supplying services in rural areas. The complementarities principle is derived from modern economic theory that attempts to explain information, incentive and contract enforcement problems of credit markets and how they result in a mismatch of resources and abilities between formal and informal lenders (Armendáriz de Aghion and Morduch, 2005; Bell, 1990; Fuentes, 1996; and Varghese, 2005). On the one hand, formal financial institutions have extensive infrastructures and systems, access to funds and opportunities for portfolio diversification, permitting them to offer a wide range of services. However they are usually at a distance from rural clients, making obtaining adequate information and enforcing contracts difficult. In contrast, informal financial institutions operate close to rural clients, possess good information and enforcement mechanisms and are typically more flexible and innovative. However, constrained by regulation (e.g. not authorized to take deposits) and a lack of resources and infrastructure, informal financial institutions are only able to offer a narrow range of services in a small geographic area (Figure 1.1). In theory linkages between formal and informal financial institutions appear to have much potential in overcoming the persistent difficulties in supplying rural financial services.

A variety of institutions exists to enable the transmission of financial information and transactions (Johnson, 2005). According to Johnson all the institutions along this continuum represent 'solutions' to the problem of financial intermediation – how to match the supply and demand of funds. Not only the institutions, but the relationships between them as well are designed to address information asymmetries, resolve enforcement problems and reduce the cost associated with the transaction. In essence, linkages afford the players, both formal and informal, the opportunity to overcome a weakness in what they can achieve on their own.

Since a wide variety of formal, semi-formal, and informal financial institutions exists, the possible financial linkages between actors along the chain are numerous. In Figure 1.2 we have illustrated this concept as a continuum of formality, with more formal institutions on the left side of the diagram on down to those institutions that are less formal on the right side. It is helpful to conceptualize linkages using a continuum of formality principle, especially since the meaning of 'formal', 'semiformal' and 'informal' varies widely across countries. In this way, it is helpful to think of linkages as mutually beneficial partnerships between upstream (more formal) and downstream (less formal) institutions. This includes linkages between institutions that are more towards the centre of the continuum, as well as those at the extreme ends.

Using case studies we...