When do Enterprises Prefer Informal Credit?

Author: Mehnaz Safavian and Joshua Wimpey
Source: The World Bank, July 2007

The authors tested the hypothesis that enterprises may forgo formal finance in lieu of informal credit by choice. They do so to avoid the additional regulatory scrutiny and harassment that engaging with the formal financial sector invites. The hypothesis is tested using enterprise level data on 3564 enterprises in 29 countries. In this sample, enterprises finance approximately 57% of their working capital requirements with external finance. This external finance comes from formal sources, such as commercial banks (53%) and informal sources (42%), such as trade creditors, or family and friends. In the sample, 14% of enterprises rely exclusively on informal finance. The analysis shows that the likelihood of enterprises preferring to only use informal finance is inversely related to the quality of the regulatory environment, particularly the quality of tax administration and overall governance. For example, it is that when an enterprise has been asked for bribes by tax inspectors, it is 17% more likely to prefer informal finance.

Download paper
Slide summary