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Formal and Informal Sectors of Credit in India

People can borrow money from different sources such as banks, cooperatives, money lenders, relatives and friends etc. These can be classified into formal sectors and informal sectors. The loan extended by banks and co-operative institutions constitutes ‘formal sector’ of credit. The functioning of these financial institutions is supervised by the Reserve Bank of India. The Reserve Bank of India ensures that the commercial banks maintain a cash reserve with it and maintains a minimum cash balance from the deposits received. Moreover, RBI ensures that the commercial banks lend money not only to profit making enterprises and business, but also to small cultivators and entrepreneurs. This is very necessary to maintain equality in the economy and protect and encourage the economically weaker sections. The commercial banks are also required to report to RBI about its amount of lending, rate of interest, etc. at periodic intervals.


The loan obtained from money lenders, relatives and friends, etc. constitutes the informal sector’ of credit. They can lend money at any rate of interest and adopt any means to recover back their money. They charge a much higher rate of interest than the lenders in the formal sector. The borrowers need to pay back a huge amount to these money lenders, and in many cases, the amount to be repaid becomes more than the person’s income. This leads to the debt-trap. There is no supervision from a regulatory body like RBI to enforce discipline of lending practices in the informal sector.


Therefore, there is a great need for more credit to be extended by the banks and co-operative societies at cheap and affordable rates, to ensure that a larger section of borrowers can prosper in their business. A huge percentage (85 per cent) of urban poor had availed of loan from the informal sector in 2003. The majority (90 per cent) of urban rich households had availed loan from the formal sector. Similarly in the rural areas, the rich households had taken loan from the formal sector whereas the poorer households had to pay a larger amount for borrowing from the informal sector. It is, therefore, necessary to open up more branches of banks and co-operatives in the rural areas to reduce the dependence on the informal sector for obtaining credit. A number of farmers’ co-operatives, weavers’ co-operatives, etc. have helped the members to obtain loans to meet their expenses. This has made cheap credit available to a large section of small businessmen in the rural areas.

Moreover, it is not only necessary to expand the formal sector, but also necessary to ensure that the benefits are extended to more people. The poorer section of the people should also receive loans at a cheaper rate. The poor sections of the society do not possess the proper collaterals to offer against taking loans. Hence, in the absence of such collaterals which are essential for obtaining loans from the formal institutions, the poor approach the money lenders from whom it is easier to obtain loans. These money lenders often lend money without any documents, keep no records of the transactions and thereby subject the poor borrowers with higher rates of interest and other ways of harassment.


The ‘Self Help Groups (SHGs)’ is a newer opportunity for the rural poor, especially women, to avail loans. These are small groups (about 15–20 members), often from the same neighbourhood, who meet regularly and save as per their ability. The members can take small loans from this group itself at an interest much lesser than that charged by the moneylenders. This has enabled self-employment opportunities amongst the members. The group members decide for themselves the purpose and amount of loan and fix the repayment schedules, etc. The group is responsible for loan repayment, hence although they do not possess any collaterals as such, even banks are willing to lend money to these self help group of women. This gives the opportunity to rural women to attain self-reliance, as well as discuss relevant issues like health and nutrition during the group meetings. The Grameen Bank of Bangladesh, founded by Professor Mohammad Yunus who was awarded the Nobel Prize for Peace in 2006, has proved successfully that not only rural women are reliable borrowers, but they can become self-reliant in small profitable activities, if supported financially.

Extending credit to a larger cross-section of the society and encourage them financially to set up their own small profitable enterprises is one of the major steps to generate employment and empower the rural poor. The inequality of economic development between the urban and rural people and between the rich and the poor can be minimised, by providing credit to the poor on easy terms and making them self-reliant.


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