Chapter 12: Interaction between the Formal and Informal Financial Sectors and its Implications on Monetary Policy: Experiences from Indian Economy

Multidimensional credit channels are often designed by policymakers to provide adequate credit to the most desirable sections of the population who often excluded from formal financial institutions. In fact, there are various institutional arrangements through which credit transactions are effected. On the one hand, there are formal financial institutions like commercial banks, regional rural banks, co-operative societies, and other government institutions, whereas, on the other, informal credit market includes landlords, private moneylenders, traders, friends, relatives, etc. Rationing of formal credit results in the under-utilization of such credit and, in turn, the excess demand spilled-over from the formal to the informal credit market. This phenomenon of spilling-over of excess demand into the informal market is known as the horizontal interlinkage. The interaction in the form of horizontal interlinkage is also supported empirically in the context of Indian economy, where credit rationing in formal market compels the excess demand to spill-over to informal market (Bell, 1990). Again another form of interaction is known as vertical interlinkage where informal lenders are viewed as having access to formal sources of lending, and the funds thus borrowed are then re-lent.