Question

What is the Imprtance of formal institutions of credit ?

Answer 1

The provision of credit has increasingly been regarded as an important tool for raising
the incomes of rural populations, mainly by mobilizing resources to more productive
uses. As development takes place, one question that arises is the extent to which credit
can be offered to the rural poor to facilitate their taking advantage of the developing
entrepreneurial activities. The generation of self-employment in non-farm activities
requires investment in working capital. However, at low levels of income, the
accumulation of such capital may be difficult. Under such circumstances, loans, by
increasing family income, can help the poor to accumulate their own capital and invest
in employment-generating activities (Hossain, 1988).
Commercial banks and other formal institutions fail to cater for the credit needs of
smallholders, however, mainly due to their lending terms and conditions. It is generally
the rules and regulations of the formal financial institutions that have created the myth
that the poor are not bankable, and since they can’t afford the required collateral, they
are considered uncreditworthy (Adera, 1995). Hence despite efforts to overcome the
widespread lack of financial services, especially among smallholders in developing
countries, and the expansion of credit in the rural areas of these countries, the majority
still have only limited access to bank services to support their private initiatives
(Braverman and Guasch, 1986).
In the recent past, there has been an increased tendency to fund credit programmes in
the developing countries aimed at small-scale enterprises. In Kenya, despite emphasis
on increasing the availability of credit to small and microenterprises (SMEs), access to
credit by such enterprises remains one of the major constraints they face. A 1995 survey
of small and microenterprises found that up to 32.7% of the entrepreneurs surveyed
mentioned lack of capital as their principal problem, while only about 10% had ever
received credit (Daniels et al., 1995). Although causality cannot be inferred a priori from
the relationship between credit and enterprise growth, it is an indicator of the importance
of credit in enterprise development. The failure of specialized financial institutions to
meet the credit needs of such enterprises has underlined the importance of a needs-
oriented financial system for rural development.
Experience from informal finance shows that the rural poor, especially women, often
have greater access to irúormal credit facilities than to formal sources (Hossain, 1988;
Schrieder and Cuevas, 1992; Adams, 1992). The same case has also been reported by
surveys of credit markets in Kenya (Raikes, 1989; Alila, 1991; Daniels et al., 1995). A
relevant question then becomes: Why do informal financial institutions often succeed
even where formal institutions have failed?