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Informal Credit

Informal Credit operations involving lending, generally at short-term, among friends, relatives, kin members, landlords, neighbours, shopkeepers, farmers, artisans, itinerant traders, marketing intermediaries, village moneylenders and other local income groups. Informal credit includes various traditional non-institutional ways of accumulating and extending credit. Although informal credit markets exist in urban areas, the term generally refers to rural informal credit markets where institutional credit facilities are absent or insufficient to cater to the needs of local professionals of different categories. Informal credits are supplied at little or no interest to farmers, local poor people and marginal professionals of various groups, relatives, and friends. Usually the traders, large landowners, and moneylenders dominate as the suppliers of informal credit.

The importance of informal credit markets in countries like Bangladesh derives from a number of factors, including their continued dominance in the rural credit market, and the services they provide to the poorest sections of the rural community. The volume of non-formal finance is greater than formal financial flows in rural areas of many developing countries. Informal lending appears to have some advantages over institutional lending, especially among low-income groups and in the remote rural areas.

Informal credit markets have their origins in the early stage of organised society. In the very initial stages of farming and barter exchange, surplus farmers, upon request from deficit farmers, used to lend food stuff and seeds to them on the basis of a promise to return the goods with some extra after the harvesting of crops. After the replacement of the barter system by metallic coins as the medium of exchange, the lending system was converted to monetary lending. In course of time, the cash credit system, though limited, started to evolve abreast of trade credit. In the absence of institutional or formal sources, the evolution process of the informal credit system was accelerated by the increased participation of moneylenders, goldsmiths and local merchants. This group of people played an invaluable role in the development of the credit market, which took a new turn in 1171, when the Bank of Venice, the first bank in the world, came into being in Italy.

Major sources of informal credit in the past were the moneylenders, goldsmiths and merchants. Moneylenders, known locally as mahajans lend money at interest and in the past, used to accept gold ornaments, silver, and brass-made plates, pitchers and tablets as security for their money. They also used to accept money from the public as deposits and pay interest on them. Although moneylenders were called usurers, their active role helped the ancient economy to flourish and established the pathway so that the institutional credit system could start. Even today, the moneylenders operate in most countries, especially in developing and less developed ones, where institutional credit is still beyond the reach of large sections of people, who are traditionally not considered as bankable. In the past, people used to deposit their savings with goldsmiths to ensure their safekeeping. Throughout the world, especially in England and other parts of Europe, the goldsmiths were rich, reliable and trustworthy. Since depositors did not withdraw all of their money at a time, goldsmiths always had a substantial amount of idle money in their hand. This gave them the opportunity to lend money to others at interest. The role of the merchant class was also important and remarkable, and conducive towards the expansion of the credit system. In the fourteenth century, a group of merchant from the Lombardy area of Italy came to England and settled in present day Lombard Street. They were known to be millionaires and used to lend money at interest. Kings and other aristocrats of the period used to borrow money from them.

Informal credit in Bangladesh The people of ancient Bengal had experience in informal credit and extra payment (interest) thereon even before 400 BC. Reference to the phenomenon is found in Koutilya's Artha Shastra as well as in the mangalkavya. However, the practice of informal borrowing and lending was given some formal shape only in the Vedic era before 1150 AD. Lending activities were then mainly centred in temples and other religious places. Informal borrowing and lending activities took the form of informal banking during the period of Manu, the prominent saint of ancient India, who advised the people to deposit their money with a person bearing good moral character, well conversant with the law, and surrounded by respectable and rich relatives.

The credit system in the sub-continent gained substantial strength during the Mughal period, when there were different types of gold coins in circulation that motivated people of different classes to engage in monetary transactions and profit-motivated credit-giving activities. Local moneylenders, banians (commercial class), capitalists and other professionals participated in trading in informal credit during this period and contributed substantially to the growth of the informal credit system. The system of lending and borrowing started to get a formal shape in 1700 through the establishment of the Hindustan Bank in calcutta, the first modern bank in the sub-continent. Among the moneylenders and other traders in credit in Mughal-Bengal, the jagat sheth family, having businesses at different important locations including Hughli, dhaka, and murshidabad, was strong enough to lend money even to the Mughal rulers. These rulers also used to borrow from other local bankers. They patronised the banking business of jagat sheth, mercantile communities, and other traders in credit, including the moneylenders, moneychangers, village merchants and shopkeepers. During the eighteenth century, money and credit transactions in Bengal were largely concentrated in the hands of Sheths, sarrafs, mahajans, and potdars who constituted private non-institutional sources of credit.

In the early eighteenth century, mahajans advanced money to cultivators before the season for grains. They accepted repayment in kind and stored the grain for a profitable market. The interest rate charged on credit by different informal providers was exorbitant and varied from two to four percent per month. English and Dutch East India Companies and Asian merchants engaged in exporting goods from Bengal to various other markets in Europe and Asia provided local producers with short term advances to increase the production of exportable goods. These credits increased the flow of funds into the Bengal economy. Farmers and artisans were also dependent on local and foreign moneylenders for credit support to finance their production. In 1720-21, English companies owed Rs 2.4 million to moneylenders, merchants and bankers in Bengal. The Dutch east india company's debt to Kasimbazar merchants, computed with interest in September 1724, was Rs 1.5 million. In March 1754, total Dutch borrowing in Bengal was Rs 2.83 million. In the three years between 1755 and 1757, the Dutch debt to the House of Jagat Sheth was Rs 2.386 million while the French owed Rs 1.5 million. Loans were given on mutual trust, sometimes without a document, or even a witness.

After the occupancy of Bengal, Bihar and Orissa by the East India Company, moneylenders, mercantile communities, and other traders in money and credit, including the famous Jagat Sheth family suffered heavy losses. The decline in informal banking in Mughal Bengal caused serious instability in different sectors of the economy. With a view to protecting the declining trend and stimulating trade and commerce, the British established several English Agency Houses in Bengal. While traditional moneylenders used to advance loans to peasants in cash or kind at a high rate of interest without seeking any control on the production process, the new credit agencies were connected with trade and commerce, and advanced money to peasants with a view to securing a portion of the peasants' produce. In the middle of the nineteenth century, the peasants' grain production for the market was largely financed by loans from grain merchants and the landlords. The dadni system provided loans to weavers, local farmers, and industrial producers who took advance money from foreign merchants and companies for supplying a particular amount of goods within a particular period.

The East India Company advanced money for the cultivation of mulberry and indigo. Peasants also took credit against the hypothecation of their crop. But such advances were not sufficient to finance the costs of transformation of agriculture from the old system to the modern one. The local money markets were too limited, unorganised, and thin to provide funds needed for agriculture.

The rates of compound interest by the village moneylenders, kabulis, jotdars, shahas, banians, telis and other informal lenders varied from 25% to 40% per annum. Debtor-agriculturists often had to sell the whole or part of the their produce at low rates to creditors to repay debts. On the other hand, the decline in the price of agricultural commodities in the years of the great depression that lasted from 1928 to 1937 increased the extent of peasant indebtedness. The British government, upon receipt of reports on exaction of interest by local informal creditors, formed the Indian Central Banking Enquiry Committee to investigate into the matter.

On the basis of the Committee's report, the finance department of the government made some suggestions to check the practice throughout India. The Bengal Moneylenders Act 1940 was adopted to regulate the activities of the moneylenders. This was an important addition to other laws such as the Usurious Loans Act 1918 or the Bengal Moneylenders Act 1933. According to the latter, interest in excess of 15% on secured loans and in excess of 20% on unsecured loans was illegal.

Following the partition of bengal in 1947, Pakistan inherited a banking and credit structure from the British regime consisting of 631 local and foreign bank offices. But the presence of informal sources of credit was also noticeable in both the provinces of Pakistan. The establishment of the country's central bank in 1948 and a number of commercial banks and other types of formal credit institutions somehow restricted, but could not abolish, the function of informal sources of credit.

When Bangladesh became independent in 1971, the country inherited a very weak credit and banking system. The formal segment of the credit system had only 1,130 branches of 12 commercial banks. The non-formal segment comprised local moneylenders and merchants, shopkeepers, and other types of lenders, who were almost non-functional during the early years of independence due to scarcity of loanable funds. Despite the rapid increases in institutional components of the rural credit market in Bangladesh, non-institutional sources continued to remain as the major sources of rural credit. Till today, the rural credit delivery system in Bangladesh is dominated by traditional or informal moneylenders who account for about two-thirds of credit delivered in rural areas.

According to some estimates for the 1990s, approximately 90% of the rural people of Bangladesh had debts. The sources of their debts are mostly individuals and informal groups including friends and relatives, rural rich people, landlords and neighbours, shop-keepers, business agents, bargamaliks, marketing intermediaries (bepari, faria, aratdar, mahajan, paikar, feriwala, dalal etc.), village moneylenders, self-help groups, chit funds, various occupational groups (farmers, fishermen, salaried employees, rickshaw pullers, petty traders, hawkers), youth groups, women's groups, neighbourhood and kinship groups, and groups of craftsmen (weavers, potters, or sweet makers). The approximate percentile share of informal credits given by different traditional sources were: relatives and friends 27%, neighbours 21%, local rich people 16%, professional moneylenders 15%, goldsmiths 1%, shopkeepers/business agents 14%, and bargamaliks 7%.

A considerable proportion of borrowings in the informal rural credit market is made against non-monetary forms of interest, which are diverse in nature. The most common forms of credit are karja/hawlat, rin, bandaki rin, dadan, paddy loan, labour loan, khaikhalashi, lagith or pattan, kot, rehan, pushani, saf-kabala, firtinama, etc. Karja or hawlat refers to a loan without interest, usually from friends, relatives, neighbours and well-wishers. Similar to karj-e-hasana of Islamic tradition, these loans are usually small in amounts, interest-free, and do not require any collateral or security. Rin refers to a loan requiring cash payment of both principal and interest. Dadan is a loan to the farmers which is given in cash for production of a crop or manufacture of a product and is to be repaid in the form of produce, the price of which is predetermined usually at lower than the normal market rate. Paddy loans involve payment in kind. The common practice is the repayment of both principal and the interest in the form of a predetermined amount of paddy.

The undertaking to supply labour for the creditors' land is another common arrangement. This practice is most common among small farmers, tenants and landless labourers who do not have adequate land to offer as security. Under this arrangement the labourers commit themselves to work in the creditors' land for the advances they receive. In the kot and khaikhalasi system of loans, land is used as security and under the common practice, the debtor, in return for a cash loan, transfers the right of using the land to the creditor for a stipulated period of time. In case of Lagith or pattan, the debtor transfers the land to the creditor for one year or so against cash. It does not involve any interest. In case of Pushani the owner of a piece of land transfers the right of use of the land to the creditor against some cash receipts for an indefinite period of time. Rehan refers to a mortgage agreement on stamped paper in which the borrower makes a promise to repay his loan under agreed terms. Saf-kabala/chukti kabala is a kind of land security, which is formalised through a deed of sale given by the borrower to the lender.

It involves the transfer of the ownership right of land until such time as the principal and interest are considered to have been paid in full. Firtinama is a document signed by the lender in case of saf-kabala in which he agrees to return the land together with the deed and documents upon repayment of loans. Mulee is also a type of informal lending widely practised mostly in barisal, patuakhali and noakhali districts. The system requires the borrowers to pay some specified amount of paddy or other crop immediately after harvest against a fixed amount of loan. Effective interest rate under this arrangement may reach as high as above 180% per annum.

Informal credit is used for both consumption and capital purposes. Consumption purposes include meeting expenses in food, clothing and medicine, as well as various household expenses and expenses on occasions like marriage ceremonies or festivals. Capital purposes include meeting costs of agricultural inputs, buying livestock and land, investment in businesses or small ventures such as running a tea shop, buying a rickshaw, organising inventory for vending etc, paying for workers, and meeting expenses for the education of children. Informal credit is also used to finance traditional rural businesses in commodities such as paddy, handloom cloth, jute, lumber or oils, etc.

The share of formal and informal credit market in rural areas was 4.53% and 95.47% respectively in 1956, 13.89% and 86.11% in 1966, 14% and 86% in 1974, and 25% and 75% in 1989. The average rate of interest on informal credit during the periods varied from 60% to 110% per annum. Increased participation of non-government organisations in the rural credit market substantially increased the volume of institutional credit in the rural areas of Bangladesh. At present, over one thousand local and foreign NGOs are providing microcredit to rural people. Despite the fact that the institutional credit had expanded remarkably in the country since the mid-1980s, informal credit continues to remain important in the rural areas. Informal credit is easily available, and is therefore, more capable of meeting the urgent needs of rural farmers and the people of other professions. Informal private credit is however, exploitative in nature and is often used for unproductive purposes. Through a detailed study of informal credit transactions in a village in northern Bangladesh, the research empirically establishes that increased access to credit from micro-finance institutions (MFIs) in Bangladesh has been unable to substitute for the higher-cost informal credit sources. It is argued that cross-financing can have a deleterious effect on the household economy in the long-run if households continuously manage loan repayment without having the ability to repay. [Abul Kalam Azad]

Bibliography Saurabh Sinha, Imran Matin, Informal Credit Transactions of Micro-Credit Borrowers in Rural Bangladesh, IDS (Institute of Development Studies) Bulletin Volume 29, Issue 4, pages 66-80, October 1998.