The underground lending sector is large in some emerging Asian economies and is often the only source of capital for households with poor credit or that lack credit records. When households and businesses in need of capital are unable to borrow from banks, they turn to private moneylenders, loan sharks or pawnshops--known as informal or underground lenders -- which may charge extremely high interest rates and use coercive collection methods.
Serving poor households and small enterprises can be a high-risk, high-cost business for banks as such borrowers have neither stable income streams nor certain repayment capabilities. In addition, these borrowers usually do not have sufficient collateral and their credit information is absent, increasing the default risk of lending to them for traditional banks. Poverty, especially rural poverty, and growing household demand for credit thus account for a relatively large part of the need for an underground lending sector in many low- and middle-income Asian countries.
In this study, we discuss several factors that lead to fairly large underground lending markets in selected Asian countries. We assess whether they can potentially disrupt economic development or, on the contrary, benefit the countries by providing access to capital to households and enterprises that do not have access through formal means. In our view, underground lending markets often trap households and entrepreneurs in a cycle of debt with high interest rates and predatory lending practices, leading to social problems and criminal activity.
We offer four market-based approaches to mitigating the negative aspects of underground lending practices:
• Increase access to formal funding sources, including microcredit institutions charging interest rates that make continued operation sustainable--balancing mission and return.
• Reduce restrictions on interest rate controls to make cost recovery on smaller, unsecured, shorter-term or higher-risk loans possible for formal lenders, increasing competition for informal or underground lenders.
• Improve the availability of financial records to lower the cost to formal banking institutions of serving target populations. For example, make land records available electronically so that ownership can more easily be proved when borrowers seek to use land as collateral.
• Increase transparency and competition among formal loan providers by standardizing the advertised total cost of loans to allow for easier comparisons of providers and highlighting the gulf between formal rates and those offered by informal lenders.