Financial dualism affects economic development through the dichotomization of resource accumulation and distribution processes. Sectoral and regional disparities are created with respect to the mobilization and allocation of funds; this results in a growth rate differential between sectors, as their development depends on their access to different sources of credit.
Therefore, it is important to study the functioning and distribution of these informal financial activities, with a view to understanding the complementarities between formal and informal financial sectors and for finding ways and means to link the two sectors, so as to increase the availability of finance for development, while minimizing costs.
It is a well-known fact that the cost of informal finance is often exorbitantly high. Accurate estimates of interest rates on informal markets do not exist; however, there are indications that these rates can be as high as 100 per cent per annum or more.
The informal sector usually makes small loans of very short terms, which in general are more expensive than long-term loans bigger in size. Clients of the informal sector are small or micro-enterprises or poor individuals, who carry higher risks than clients of the formal sector. While the opportunity costs of funds may also be higher for individual money-lenders, however, the transaction cost of lending in the informal sector is lower than in the formal sector, which has to incur high intermediate input and administrative costs, to acquire information about borrowers, to monitor loans and fiscal charges. On balance, then the high interest rate of the informal sector might result more from the monopoly position of informal lenders, because small borrowers seldom have other alternatives.
Despite the absence of any regulatory framework and the minimum collateral requirements, the informal sector exhibits lower default rates. Closer screening of applicants and stricter monitoring of loans may explain this result. The proximity of residence and work place of lenders and borrowers may enable the former to obtain information on the true financial situation of their clients and to monitor continuously their whereabouts and business activities. Pressure by other members of the community ("peer pressure") on bad payers to force them to pay in order to preserve the creditworthiness of the community is also effective in exerting discipline on debtors.