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Information, Informal Finance and SME Financing

Lin Yifu and Sun Xifang(CCER,Peking University)  
Informal finance exists extensively and has been playing an important role in SME financing in developing countries. This paper tries to rationalize the extensiveness of informal finance. To do so, a model including formal and informal lenders, high- and low-risk borrowers with or without sufficient collateral is set up. The informal financial lenders have advantage over formal financial institutions in collecting “soft” information about SME borrowers to overcome the information asymmetry. The paper shows that the credit market in which informal finance is eliminated will allocate funds in some inefficient way, and once informal finance is allowed to co-exist with formal finance, the allocation efficiency of credit resources can be improved, a socially optimal outcome is shown here.
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