Second, informal finance addresses information asymmetry by using layered information and various low-cost informal information sources. Community-based organizations such as chambers of commerce and guilds, production organizations such as specialized technology associations for farmers or cooperative production associations, intermediaries such as reputed celebrities in local areas, and other organizations with abundant access to information, such as automobile clubs, pigeon-raising clubs, and temples, are used to distinguish borrowers, screen lending projects, and reduce credit risks. For example, some relatively large enterprises can gauge farmers’ credit demand and evaluate credit risks through their long-term supply and marketing relationship with farmers. More importantly, lenders can reduce repayment risks by linking loan repayment with proceeds. The lending shops emerging in some areas are established on a natural relationship with production cooperatives. Such practices also can allow the informal financial market to play an important part in interest rate discovery.
Third, informal finance can guarantee loan security by using social capital—forms of informal agreement based on social networks, informal organizations, and social customs—to replace collateral or courts. Social capital represents a kind of virtual collateral or court, and functions similarly. The difference is that most social capital is established by usage, thus offering a much less expensive way to settle lending disputes.
In the early stage of economic development, informal finance can dissolve risks before, during, and after loan issuance, making it a cheaper institutional arrangement than formal finance. For example, before a loan is issued, informal finance can use various information sources to screen borrowers and lending projects, thus preventing reverse selection of riskier borrowers, who are more willing to apply for loans even when the interest rate is high. Such screening can help reduce risk before a loan is made. Moreover, when a loan is provided, the lender can prevent moral hazard on the part of the borrower, because the purpose of the loan is clear. Finally, after a loan is provided, a lender can prevent a borrower’s strategic default by using peer pressure, group punishment in which all informal financial organizations respond together to stop lending to the defaulter, or a boycott of the defaulter’s business.
Fourth, the relationship between informal and formal finance is both competitive and supplementary. Studies have shown that competition from informal finance exerts a positive effect on the governance structure and the performance of formal financial institutions. On the one hand, competition promotes innovation by formal financial institutions; on the other hand, formal financial institutions can learn from informal finance. International experience also indicates that formal finance can utilize the information advantage of informal finance when lending to start-ups, which can become clients of formal financial institutions after establishing a credit record. In some localities, formal and informal financial institutions even diversify credit risk by issuing joint loans.
Rural Lending Shops
Any institutional innovation, particularly an inductive institutional innovation, needs an enabling environment. Private enterprises in the PRC faced discrimination before booming under relaxed regulation and an improved operational environment. Presently, a friendly policy environment is encouraging the diversification of financial organizations in the PRC, and diversified real economic entities demand increasingly diverse forms of finance and financial innovation.
The new rural financial organizations are both familiar and strange for many farmers. Before the reform of the collectively owned economy in the countryside, production cooperatives, supply and marketing cooperatives, and lending shops (or credit cooperatives) were the three major cooperatives in rural areas. However, the function of these cooperatives was to prepare for the transformation to a collectively owned economy. It has become obvious that, after being stripped of distribution and/or sales and credit, production cooperatives cannot operate independently and efficiently. This is particularly true of RCCs, because such segregation severed the otherwise inherent link between production and capital allocation, artificially creating information barriers between production cooperatives and lending cooperatives and thus making it difficult to match capital allocation with production demand. Emerging production cooperatives (also known as rural special technique associations or the companyplus-farmer model) successfully link production and the market, and rural lending shops represent a model that connects supply, sales, production, and credit.
Private enterprises in the PRC faced discrimination before booming under relaxed regulation and an improved operational environment
Rural lending shops can help address, at low cost, issues that are costly for formal financial institutions such as credit cooperatives. The purpose of merging Baixin Rural Lending Shop and Baixin Farmers’ Cooperative in Jilin Province, for example, is to provide funds for the farmers’ cooperative. Though the two cooperatives have their own names, they are one entity; the farmers’ cooperative provides the lending shop with a platform to raise funds. Members of the farmers’ cooperative have detailed knowledge of members’ funding needs, integrity, repayment ability, and capital source for loan repayment (e.g., income from sheep sales). Such knowledge helps address information asymmetry and simplifies loan assessment.
In addition, the farmers’ cooperative is an institutional arrangement through which borrowers may repay loans. If a member intentionally defaults, the farmers’ cooperative may deduct the proceeds of a member’s sales to repay the loan or may terminate his or her membership. Because all members live in the same or adjacent communities, peer pressure subjects the defaulting member to sanction in every aspect of production and life. Such punishments prevent borrowers from defaulting, and loans are repaid on time even in the absence of collateral, litigation, government intervention, or other means.
One advantage of informal institutional arrangements is their low cost, which makes it possible to meet even the smallest demand for credit
Initially, lending shops were an informal institutional arrangement that relied mainly on interpersonal trust, local culture, folk customs, and personal acquaintance. Such informal institutional arrangements are difficult to regulate through word and contracts, making them unofficial and informal, as opposed to laws and regulations. One advantage of informal institutional arrangements is their low cost, which makes it possible to meet even the smallest demand for credit. In addition, informal institutional arrangements may be exempt from the regulatory and other types of examinations required in formal institutional arrangements. Of course, informal institutional arrangements also are subject to constraints, such as difficulty in accessing legal and administrative assistance in case of disputes. In this sense, lending shops are similar to private lending organizations.
The risks faced by lending shops are similar to those faced by farmers’ cooperatives. Lending shops are generally small, with strong homogeneity, meaning that similar productive or operational risks affect a large number of their members. Baixin Rural Lending Shop, for example, would suffer large numbers of defaults or even go bankrupt in the event of plague or other disease, or if market prices fluctuated, and its self-rescue ability is weak.
Thus, institutional innovations are needed to forestall the risks related to lending shops. In the beginning, government has an important role to play. First, the size of lending shops must be rigorously restricted to ensure that financing occurs only among members. Second, productive and operational risks must be diversified. For example, farmers’ cooperatives may cooperate with the government, insurance companies, and disease prevention and quarantine agencies to prevent the spread of plague. Governments can subsidize some insurance premiums and can encourage the insurance sector to create insurance products tailored to local needs. Disease prevention agencies can share partial risks or benefits through holding a stake in the form of technology. Third, a risk fund can be established with interest income and partially subsidized by governments. Finally, a loan guaranty fund can be created to compensate for losses from natural disasters or accidents beyond human control.
In addition to the adoption of institutional innovations to diversify risks, rural financial institutions also should put in place innovations to reduce operational and transaction costs, especially in