Informal sector credit

Also called: Informal lenders, moneylenders · Topic: Rural Credit, Microfinance and Financial Inclusion · NCERT: Class 10, Ch 3 "Money and Credit"

Meaning

Informal sector credit means loans from moneylenders, traders, employers (often landowners), relatives and friends. No official body supervises these lenders. They keep no records, and each lender sets their own interest rate and repayment terms.

It matters because this credit mostly reaches the poor and landless, who cannot offer the collateral banks ask for. It usually costs much more than a bank loan and can pull borrowers into a debt trap. The main formula is:

Interest = Principal × Rate × Time (simple interest)

Explanation

How it works: the four terms of credit

Every loan comes with terms of credit (the conditions of the loan). Informal lenders set all four themselves:

• Interest rate: much higher than a bank's, and the lender decides it. Shyamal paid 5% a month to a moneylender, which is 60% a year.
• Collateral (an asset the borrower pledges, which the lender can take if the loan is not repaid): few formal papers are needed. Instead, the loan is often tied to the borrower's crop, labour or land.
• Documents: very few or none, so the poor find it easy to borrow.
• Mode of repayment: cash, the crop, or the borrower's labour.
• Recovery: there is no legal process. Unfair methods are possible, such as threats or taking the borrower's land.

Two special forms

Interlocked credit. Here a loan in one market is tied to a deal in a second market.

• The trader gives seeds and fertiliser on credit only if the farmer promises to sell the crop to him.
• At harvest, prices are low, so the trader buys the crop cheap. He sells it later at a higher price.
• The farmer cannot look for a better buyer. The credit market and the produce market are "locked" together.
• The result is distress sales (selling the crop at a low price because the farmer urgently needs cash).
• Sonpur example: Shyamal borrowed from a trader at 3% a month, plus a promise to sell his crop to that trader.

Labour-tied credit. Here the borrower repays the loan by working for the lender.

• Rama, a landless labourer, borrowed from her landowner-employer at 5% a month and repaid through labour. She owes ₹5,000.
• She takes a fresh loan before the old one is cleared, so her debt keeps growing. This comes close to bonded labour.
• The landowner is her only lender. This gives him power over both her wages and her loans.

Worked example: how costly informal credit is

Same loan, two lenders. Both farmers borrow ₹10,000 for 4 months.

• Shyamal (trader, 3% a month): ₹10,000 × 0.03 × 4 = ₹1,200
• Arun (bank, 8.5% a year): ₹10,000 × 0.085 × (4/12) ≈ ₹283
• Shyamal pays more than 4 times as much interest. The trader also buys his crop cheap.

Monthly rate vs annual rate.

• 5% a month = 60% a year as simple interest.
• Suppose unpaid interest is added to the loan every month (compounding). Then the yearly cost is (1.05)¹² − 1 ≈ 79.6% a year.
• This is why Rama's debt keeps growing.

What pushes people towards informal lenders

• Collateral trap: banks ask for land and papers. Arun had 7 acres, so he got a bank loan. Shyamal (1.5 acres) and Rama (landless) could not get one.
• Few formal options nearby: where there are fewer bank branches or cooperatives, people depend more on informal lenders.
• Debt trap chain:
• high interest → most of the income goes to repaying the loan;
• little money is left for the family → the borrower takes a new loan to survive;

• the debt rises → the lender takes land, crop or labour.

• What reduces it: more formal credit (bank branches, RRBs, cooperatives, PSL targets), plus SHGs (self-help groups), cooperatives like Krishak, and warehouse-receipt loans.

In India

• Who measures it: the NSO measures it through the All India Debt and Investment Survey (AIDIS). AIDIS calls informal lenders "non-institutional agencies": moneylenders, landlords, traders, relatives and friends.
• Latest data (AIDIS, NSS 77th round, survey in 2019, debt as on 30 June 2018):
• 34% of rural outstanding cash debt was owed to non-institutional agencies, and 66% to institutional agencies [2].
• 10.2% of rural households owed money only to non-institutional agencies. About 7% owed money to both [2].

• Rural incidence of indebtedness (the share of households with any outstanding loan) was about 35%: cultivators 40.3%, non-cultivators 28.2%. Urban incidence was 22.4% [2].

• NCERT picture: in the Class 10 urban graph, 54% of poor households' loans are informal, against only 17% for rich households. NCERT says the formal sector meets "only about half" of rural credit needs.

• Long-term trend:
• 1951: moneylenders supplied about 70% of rural borrowing (All India Rural Credit Survey).
• 1954: the Gorwala Committee said rural credit "fails in quantity, fails in quality, fails… to reach the right people".
• After 1969 (social banking): the institutional share rose to about 61% by 1981. It stagnated or dipped between 1991 and 2002.

• 2018: the institutional share reached 66% [2].

• Who regulates it: the RBI supervises banks and cooperatives (with NABARD for rural cooperatives and RRBs). It does not supervise informal lenders the way it supervises banks.

• Policy tools to reduce it:
• Priority Sector Lending (PSL), a rule that makes banks lend a fixed share of their credit to neglected sectors. Targets are 40% total, 18% agriculture, 10% small and marginal farmers and 12% weaker sections, each as a share of ANBC or CEOBE, whichever is higher [3].
• PMJDY (2014): over 56.16 crore accounts by August 2025 [4]. A bank account is the first step into formal credit.

Don't confuse with

• Formal sector credit: loans from banks and cooperatives. The RBI supervises it, interest is low and regulated, and recovery is by legal process. Informal credit has no supervisor.
• Interlocked credit vs labour-tied credit: both are types of informal credit. Interlocked credit ties the loan to a crop sale to a trader (Shyamal). Labour-tied credit is repaid through work for the employer (Rama).
• Incidence of indebtedness vs share of debt: incidence is the % of households that have any loan (rural about 35%). The 34% non-institutional figure is the share of the amount of debt [2].
• Bank account vs credit: a PMJDY account gives access to banking, not a loan. Having an account does not end dependence on moneylenders.

Prelims Hooks

• Informal lenders (moneylenders, traders, employers, relatives, friends) have no supervisor, keep no records and charge higher interest. The RBI does not regulate them the way it regulates banks.
• Terms of credit = interest rate + collateral + documentation + mode of repayment.
• AIDIS 2019 (NSS 77th round, data as on 30.06.2018): rural outstanding cash debt was 34% non-institutional and 66% institutional [2].
• Trap: rural incidence of indebtedness is higher for cultivators (40.3%) than for non-cultivators (28.2%). Yet non-cultivators depend more on informal lenders [2].
• Interlocked credit links the credit market and the produce market, and leads to distress sales.
• 1951: moneylenders supplied about 70% of rural credit. The Gorwala Committee (1954) said rural credit "fails… to reach the right people".

Mains Points

• Collateral decides who gets cheap credit (GS-III, inclusive growth):
• banks lend against land, so small and landless farmers turn to moneylenders (Arun vs Shyamal; cultivators vs non-cultivators in AIDIS) [2];

• fixes: loans judged on cash-flow and transaction records, SHG joint liability, e-NWR pledge finance and identification of tenant farmers.

• Expansion vs distribution:

• the institutional share rose from about 30% (1951) to 66% (2018) [2];
• but about a third of rural debt is still informal, and it falls mostly on the poor;

• PSL sub-targets for small and marginal farmers and weaker sections target this [3]. But banks can meet targets by buying PSLCs, which can hide gaps on the ground.

• Credit reform alone cannot break the lender's grip:

• under interlocked and labour-tied credit, one lender controls the loan rate, the crop price and wages together;
• freeing the borrower needs credit reform plus marketing support (warehousing, e-NAM, MSP) and labour reforms;
• PMJDY accounts [4] must also turn into affordable, well-timed loans for the poor.

Related concepts

• Formal sector credit
• Interlocked credit
• Labour-tied credit
• Loan against warehouse receipt

Read more

• Formal vs informal credit: who lends, on what terms, and who gets what