How urban informal credit markets work in Bangladesh
Informal credit is a non-institutional and unregulated way of extending credit to loan seekers, where money is lent by private individuals. Informal credit market plays a significant role in channelling funds mainly to poor borrowers both in rural and urban areas. A large number of people depend on informal credit markets since the formal credit system has some issues that may deter a section of people, especially the poor, from taking loans from it.
There are some compelling reasons for which informal credit markets prevail in an economy. In rural areas, formal financial institutions cannot reach all potential borrowers because of their faulty loan production technology. Rural borrowers have demand for small loans and providing them with service with costly bank branches is not profitable. Thus, many rural borrowers depend on the informal credit market. Similarly, a section of urban people also depends on informal credit markets because formal financial institutions fail to provide customised financial services to the poor through their complex service delivery system.
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In Bangladesh, most of the microfinance institutions (MFIs) work in rural areas, targeting the poor and providing small loans without collateral. Hence, loan seekers have easy access to financial services. Formal financial institutions cannot serve the urban poor as there is a mismatch between demand and supply. In addition, the number of MFIs in urban areas is very low, although there is a high demand for small and collateral-free loans in urban areas too. Consequently, a large number of the urban poor depend mainly on informal credit markets to reduce their liquidity constraint.
There have been many studies on informal credit markets in rural Bangladesh. But the current understanding about urban informal credit markets is controlled by a limited number of empirical studies. Until we know the state of urban informal credit markets, a major aspect of this sector will remain unexplored.
In 2023, I conducted a study on the situation of the urban informal credit market in Dhaka city. I used personal interviews to collect data between July and October 2023 from 400 respondents who took informal loans. The respondents ranged from tea stall owners and rickshaw pullers, to hawkers, domestic helps, and others, considering that they come from the poor section of society. Of the respondents, 80 percent were male and 20 percent female. Meanwhile, 88 percent were married and the rest unmarried, divorced or abandoned. Rickshaw pullers (32 percent) were the largest group of borrowers, followed by hawkers (25 percent), tea stall owners (21 percent), and domestic helps (20 percent).
The study found that all respondents took loans from different sources in the previous 12 months. Among them, 24 percent took loans from moneylenders, 13 percent from local income groups, seven percent from dadon loan (a cash loan for crop production or product manufacturing, which is to be repaid in the form of produce, the price of which is predetermined, generally lower than the normal market price), and only five percent from goldsmiths. Twenty percent borrowers took loans from relatives, nearly 17 percent from neighbours, and almost 11 percent from friends.
The average size of the loan was Tk 25,580, with the range between Tk 2,000 and Tk 400,000. The most popular amount was found to be Tk 20,000. Nearly 54 percent loans had the value between Tk 5,001 and Tk 20,000, and 94 percent between Tk 2,000 and Tk 50,000. These findings suggest that informal lenders mainly provide small loans, but there is also demand for large loans from these lenders.
The study also found that the average interest rate was 24 percent, with the range between zero and 250 percent. Of the total loans, 75 percent had the interest rate less than or equal to 30 percent. Put it differently, 25 percent paid an interest of more than 30 percent. The prevalence of low interest rates is because 45 percent of borrowers took loans from their affluent relatives, well-off neighbours and generous friends at zero or minimum interest rates.
Informal loans were taken for both productive (income-generating) and unproductive (consumption) purposes. The highest demand for loan, about 36 percent, was for doing business, followed by 21 percent for treatment, 10 percent for purchasing goods like TV, refrigerator, etc, nine percent for weddings—ceremonies and dowry payment—and eight percent each for purchasing rickshaws/vans and repaying another loan. About 56 percent loans were taken for unproductive purposes. The result is quite normal because formal credit markets do not extend loans for such purposes.
Sixty-nine percent of the loans were granted without collateral. Those who were extended loans with collateral placed different types of collateral: third-party guarantee (48 percent), gold/silver (24 percent), mortgage/immovable asset (19 percent), and rickshaws/vans (nine percent). The informal credit market also requires collateral when the loan size is larger, and the borrower is new and perceived to be risky and has no third-party guarantee.
The trend of defaulted loans was found in the informal credit market as well. About 30 percent of the borrowers defaulted on loans. The main reason for that was high household expense (38 percent), followed by loss in business (30 percent), accidental cost (29 percent), and lack of financial discipline (three percent). Borrowers failed to repay the loans mainly because of sluggish pace in business. Some borrowers (20 percent) diverted loans to non-productive uses such as consumption, medical treatment, household expenditure, which also led to loan default.
The most dominating consequence of loan default was harassment—verbal abuse, physical assault, threat in public, and others—by lenders (71 percent), followed by absconding (14 percent) and loss of collateral (11 percent). Sometimes, a lender sealed the house of a borrower to compel them to repay the loan.
About 51 percent of respondents borrowed from the informal credit market because they found it easy. Meanwhile, quick funding attracted 19 percent of borrowers, no collateral requirement induced 14 percent of borrowers. Less paperwork and the unavailability of formal credit encouraged seven percent and six percent, respectively.
As the study has shown, there are many practical reasons for which borrowers take loans from informal lenders. They don't need to make any periodic savings; rules and regulations are not rigid; there is also flexibility in loan size and the repayment of instalments; and at times, borrowers don't need to even mention their loans' purposes. This makes borrowing trouble-free. Moreover, informal loans are sometimes a matter of verbal agreement; borrowers don't need to produce paper documents and fill out an application form, and loan disbursement is done very quickly, often without collateral.
However, in the absence of regulations, informal credit markets are highly exploitative too. Therefore, banks, which are the main suppliers of formal finance in Bangladesh, must be proactive in reducing the scope of informal finance, because the sizeable presence of informal finance in an economy does indicate a big failure of the formal credit system.
Dr Md Main Uddin is professor and former chairman of the Department of Banking and Insurance at the University of Dhaka. He can be reached at mainuddin@du.ac.bd.
Views expressed in this article are the author's own.
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