Chapter 3 · Question 5

Compare formal and informal sources of credit.

Answer

Direct Answer

Formal credit comes from banks and cooperatives and is supervised by the Reserve Bank of India. It usually has lower interest rates and written rules. Informal credit comes from moneylenders, traders, relatives, or employers and may charge high interest without strong regulation.

Simple Explanation

Formal credit (banks, cooperatives) is RBI-regulated, charges lower interest, and requires paperwork and collateral. Informal credit (moneylenders, traders) is unregulated, charges very high interest, and often traps poor borrowers in debt.

Exam-Ready Structure

The sources of credit in India can be broadly divided into formal and informal sectors: Formal sector credit: • Sources: Commercial banks (public and private), regional rural banks, cooperative banks and societies, microfinance institutions. • Regulation: Supervised and regulated by the Reserve Bank of India (RBI), which sets norms for lending, interest rates, reserve requirements, and reporting. • Interest rates: Generally lower and standardised. The RBI periodically reviews these. • Collateral: Required for most loans — land, property, fixed deposits, etc. • Documentation: Formal paperwork required — identity, address, income, asset proof. • Terms: Written contracts, fixed repayment schedules, legal recourse in case of default. • Access: More accessible to those with regular income, formal employment, and assets to pledge. Poor and marginalised groups often find access difficult. • Benefits: Transparent terms, legal protection for borrowers, lower risk of exploitation. Informal sector credit: • Sources: Moneylenders, traders, landlords, relatives, friends, employers. • Regulation: Not regulated by the RBI or any formal authority. • Interest rates: Very high and arbitrary — often exploitative (e.g., 60-100% per annum). • Collateral: May or may not be required; sometimes the borrower's future labour or crop is the security. • Documentation: Little or no formal paperwork; often based on personal relationships. • Terms: Verbal agreements or simple written notes; can be highly abusive — bonded labour, confiscation of land, or perpetual debt. • Access: Easier for the poor — no documentation, quick availability, and no formal procedures. • Problems: Debt trap — borrowing to repay old loans; total dependence on the lender; exploitation. Current situation in India: The majority of rural households still depend on informal sources for a large share of their credit needs, especially the poor. Government policy aims to expand formal credit — through bank branch expansion in rural areas, Kisan Credit Cards, Self-Help Groups linked to banks, and direct benefit transfers — to reduce dependence on costly and exploitative informal credit.

Key Points

Formal credit comes from banks and cooperatives and is supervised by the Reserve Bank of India.
It usually has lower interest rates and written rules.
Informal credit comes from moneylenders, traders, relatives, or employers and may charge high interest without strong regulation.