It is argued that African financial markets are highly fragmented, creating both formal and informal structures.
While formal financial markets are largely controlled by the Capital Markets Authority (CMA), informal financial markets (IFMs) are outside the CMA’s regulatory and supervisory control.
IFMs include Shylocks, merry-go- rounds (chamas), pawn brokers, credit societies, and traders. IFM lenders are also outside the radar of the Central Bank of Kenya.
Formal and informal financial markets serve different clientele with no linkages between the clientele served. It is therefore unclear whether the existence of informal financial markets presents a problem or a solution to the fragmentation of African financial markets.
Historically, money lenders were regarded as parasites who exploited impoverished peasants due to the high interest they charged. For instance, some charged over 30 per cent per month which translates to more than 360 per cent per annum.
From the formal sector perspective where banks charge about 14 per cent per year, the interest charged by money lenders is a rip-off.
But how many can access funding from banks? Today, informal lenders provide efficient financial services to a large clientele ignored by the formal sector. In many developing countries, the informal sector account for over 60 per cent of total lending.
In spite of the role played by IFMs, some studies argue that liberalising restrictive policies can expand the formal sector leading to the elimination of informal lending. This argument is not in touch with grassroots reality.
Financial transactions involve the exchange of money in the present for a promise to pay in future. However, most lenders lack the ability to establish whether a borrower will actually pay.
This problem is due to information asymmetry, adverse selection and moral hazards in credit markets.
Information asymmetry occurs where one of the parties to a financial transaction has more information than the other. In most cases the borrower has information about his financial position and the purpose of the credit he is taking while the lender is in the dark.
Adverse selection occurs when there’s a lack of symmetric information prior to a deal between a borrower and a lender.
On the other hand, moral hazard occurs when there is asymmetric information between the two parties and change in behaviour of one party (in most cases, the borrower) after the lending transaction has been concluded.
Imperfect information may lead to market failures that hinder risk management causing wide differences across lenders in relation to the cost of screening, monitoring and enforcing loans.
As demand for loans exceeds supply, adverse selection and moral hazard increase causing lenders to resort to non-price rationing rather than raise interest rates.
Information asymmetry is prevalent in low-income economies where information flow is limited and financial information is lacking or costly to obtain.
Information gathering costs for large financial institutions keep rising causing lenders to shun the market. This creates opportunities for informal financiers who can easily gather information at low cost using local networks.
In addition, legal system weaknesses such as lack of title deeds and the land ownership transfer problem can affect the cost of loans.
This forces formal lenders to shun loaning and decline some securities due to absence of markets for confiscated assets in the case of default.
Informal financial markets address this problem by use of personal relationships, social sanctions and various collateral substitutes such as reputation, group responsibility and interlinked transactions (loan linked to purchase of a tangible commodity like water tank).
IFMs effectively operate on one side of the market, specialising in some specific target clients, use limited legal documentation and are largely relationship based.
Parliament recently introduced a law which caps banks’ lending rates at four per cent plus the Central Bank Rate (currently at 10 per cent). This was informed by banks’ perennial failure to lower lending rates even when the CBK lowered Treasury bill rates.
However, excessive government intervention leads to inefficient and underdeveloped financial markets. Interest rate ceilings or caps tend to increase demand but reduce supply of funds, forcing lenders to ration credit by other means.
Kenya should have a supportive legal and regulatory framework by passing laws which promote the growth of informal financial markets.
Credit: CNBC Africa