The study examined linkages between formal and informal financial institutions in South Eastern Nigeria. The area was purposively chosen because of the intense economic activities including borrowing and savings of both the formal and informal financial institutions in this area. The objectives of the study were: to identify the financial institutions in the area and describe the operations of the formal and informal financial institutions; identify areas that formal and informal institutions were linked and the institutional factors that facilitated such linkages; determine major constraints to linkages; determine strategies that would enhance linkages between formal and informal financial institutions and on the basis of the findings, make recommendations for policy and further research. Multistage random sampling procedure was used to get 36 formal and 38 informal financial institutions for the study. Two sets of structured questionnaire for formal and informal financial institutions were employed to collect primary data. Also secondary data were collected on the 2007 financial records from both sectors. The study was guided by two null hypotheses. Data generated were analyzed using descriptive statistics, probit regression and exploratory factor analysis. Thirty eight (38) informal and thirty six (36) formal financial institutions were identified. Of the twelve possible areas considered for linkages, the institutions were linked in 6 areas. Summary statistics on institutional factors that facilitated linkages found years of business experience, interest rate on loan, rate of loan recovery, and number of years of business operations, significant factors for linkages between financial institution. Financial institutions grouped 5 major constraints in linking with each other as poor legal and regulatory systems, lack of confidence, problem of communication, poor capacity building and institutional rigidities. The institutions grouped three (3) major strategies that would enhance linkages to be the provision of conducive legal and policy environment to ensure confidence and human/organizational upgrading of the informal sector. In the same way the informal institutions and institutional adjustment. Based on the constraints to linkages, the following recommendations were made; providing effective judicial system for protecting property rights with official recognition of informal financial institutions and their inclusion in regulated reforms; effective use of micro finance banks as second-tier regulatory body; provision of tax relief on profits granted to banks that allocate credit through informal sector; improving the ability of banks to reduce loan losses through the use of local sanction to enforce repayment; effective networking of all informal financial institutions; human upgrading though periodic staff training and adapting existing banks to the rural environment of informal financial institutions.

Most business opportunities are not exploited in developing nations. Some, when started are abandoned as a result of lack of funds. The above scenario has had negative consequences on the growth of the economy. One of the major economic goals of Nigeria is a satisfactory and sustainable economic growth (NEEDS, 2004). Economic growth depends in part on efficient financial market. A financial market is efficient to the extent it brings about efficient allocation of resources including credit (Yaron, 1994).

Credit, based on sources and extent of government supervision, has been broadly classified into formal and informal (Aryeetey, 1997). The formal financial sources are those under the direct supervision of the Central Bank of Nigeria (CBN). They include commercial banks, rural banks, investment houses, insurance companies, and financing companies. These institutions have loan-able funds at their disposal. The volume of credit they give may likely meet the credit needs of borrowers who meet their lending conditions (Poyi, 2000; Mkpado and Arene, 2007). The formal institutions however have such problems as high transaction costs, low level services to customers, long and tedious bureaucratic procedures, poor information about borrowers among other weaknesses (Atieno, 1994). On the other hand, informal financial institutions have acceptable credit programmes, cheap outreach, enforcement mechanism and good information about borrowers but they do not provide enough credit to borrowers.

Information is a major factor in resource allocation in financial market. For instance, a lender’s willingness to lend may hinge on the information about the borrower. The absence of information may explain why lenders choose not to serve some individuals (Yaron, 1994).

Information imperfections are important in explaining the segmentation of credit markets into formal and informal. Information flows are typically efficient over relatively close distances and within social groups, as found in the informal setting. This is one of the advantages the informal financial sector has over the formal financial sector (Bell, 1990).

The failure of formal financial institutions such as banks to serve poor borrowers is due to a combination of high risks, high costs and consequently low returns associated with such businesses. To lower these risks, banks screen potential borrowers to establish the risk of default; they create incentive for borrowers to fulfill their promises to repay; and they develop various enforcement strategies to encourage repayment, to the extent of available information. Scarcity of information results in information asymmetries between borrowers and lenders (Varghese, 2005). In order to address this problem, banks often attach collateral requirements to loans. Unfortunately, conventional collateral requirements usually exclude poor borrowers, who seldom have sufficient forms of conventional title.

Informal lenders have often, innovatively succeeded in limiting loan default. For instance, by lending to Self Help Groups (SHGs), the joint liability and social collateral thus created ensure strict screening and monitoring of members (Mosley 1996; Nathan, 2004). From the foregoing, each financial institution has several strengths and weaknesses. There is no unique financial institution that can provide adequate financial services to borrowers.

To attain financial viability and sustainability in the face of these weaknesses, the new institutional economics and development theory suggests that formal and informal financial sectors be linked. The vision is of models, or principles that integrate both sectors; where different sectors exploit each other’s comparative advantage in cost-effectively delivering financial services to borrowers. Such integrated and partnership efforts will bring about purposeful and effective solution....

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