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Challenges in Microfiance Banking Sector of PakistanComparative Analysis of Khushali Bank & First Microfinance Bank

PMN is interested in promoting Microfinance services among its member

organizations i.e. First Microfinance Bank & Khushhali Bank etc. It commissioned

this study to obtain market research that its members could use to design and deliver

Microfinance services for low-income micro entrepreneurs throughout Pakistan.

Using a set of practical tools, the study obtained information about key financially-

stressful events and risks, and the respective coping mechanisms used by

microfinance clients in Pakistan. It evaluated the effectiveness of available coping

mechanisms and examined the range of formal and informal financial options

available to the poor. Based on this information, it then formulated and tested several

Microfinance service concepts as part of PMNs comprehensive Microfinance service

development. In the end, although the research focused initially on the demand for

Microfinance, the data revealed a demand for risk-managing financial services

defined more generally. Thus, this thesis recommends other risk-managing services

such as savings and emergency loans where appropriate.

My thesis is organized as follows. First, I present a brief overview of

introduction about microfinance and the methodology used to carry out the research.

Then, we review the literature regarding the risks and economic stressors that

microfinance clients face and comparing the performances of main microfinance

institutions i.e. First Microfinance Bank & Khushhali Bank etc. After that discussion

of respondents principal risk-management strategies and their effectiveness for

coping with economic shocks follows comprising analysis of people who help in

research. We then present service concepts that the research team developed and

tested with a small sample of clients. We close with a summary of the thesis, findings

and recommendations for PMN and these two banks. The recommendations

emphasize the need for: client financial education; a better working relationship with

the financial institutions; and a systematic service development process for

Microfinance.

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1.2 BACKGROUND OF THE STUDY

In the beginning, people consumed what they grow. But with the passage of

time human invented modern methods of cultivation and started to get surplus food.This surplus food gave birth to trade. People start to exchange things in return for

food. As people became sufficient in the food supply, they had also started trade in

terms of money.

This factor of money brings a new dimension in the socio-economic structure

of the society. The most defining moment in the history of the mankind is the

Industrial Revolution, which took place in the seventeenth century in Europe. This

revolution changed the history of mankind significantly. Europe started making

progress by leaps and bounds because of this revolution. They influenced the whole

world and finally became the master the whole world. After the industrial revolution,

financial institutions came into being. They came into existence as a result of the fact

that some people had excess of money and others had scarcity of money. Financial

institutions started to play an important role in the development and progress of the

people.

Like everyone else, most poor people need and use financial services all the

time. They save and borrow to take advantage of business opportunities, invest in

home repairs and improvements, and meet seasonal expenses like school fees and

special day celebrations. The financial services available to the poor, however, often

have serious limitations in terms of cost, risk, and convenience. Moneylenders, for

example, often charge high interest rates on loans. Buying goods on credit is far more

expensive than paying in cash. Local rotating savings and credit circles take deposits

and give loans only at rigid time intervals and in strict amounts, and often result in the

loss of members' money.

Commercial Banks were focusing on a very limited part of the community

because they considered it risky to finance the poor rural people who cannot offer

heavy collateral securities against bank loans The risk perception of the micro finance

market emerged from the attitudes that the poor are not bankable, to the general lack

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of credit discipline in the over all economy and to the low ability of contract

enforcement. Micro Credit industry came into existence as a source for the massive

communities of the 3rd world countries who were deprived of even the basic needs of

food, health and shelter. Up-till now 44 countries made use of micro credit

programmes and there were 36 million clients of micro credit all over the world

(Micro credit Summit1997).

1.3 STATEMENT OF THE PROBLEM

The present study is about the issues and challenges of micro financing

institutions in Pakistan. Service quality offers a sustainable competitive advantage to a

bank because it creates value and also customer satisfaction. However, service quality

is reduced drastically by service breakdowns. The results of service breakdowns are

customer dissatisfaction and possibly customer defection depending on the customers

trust, knowledge and the availability of alternative service provider. In the banking

sector, to maintain and having a closer relationship with the entire or existing

customers are very important.

The maintenance of consumer trust in the microfinance banking industry is of

considerable importance as it can impact on the likelihood of retaining existing

customers and attaining new ones. Furthermore, trust in a bank can also be more

important to a bank customer than price and mark up. So, each bank must make sure

that their services fulfill their customers needs and wants.

The focus on this research is to identify the common relationship marketingunderpinnings such as trust, commitment, empathy, values and conflict handling on

customer loyalty in banking sector. This research will also look whether all

dimensions mentioned contribute equally or differentially towards the loyalty of the

customer. My thesis is concerned on mainly issues issues and challenges of micro

financing institutions in Pakistan because they acquire service with certain

expectations, and, for any number of reasons, those expectations were not met. First

Microfinance Bank & Khushhali Bank help in this scenario controlling delays,

failures and troubles like problems to the customers of microfinance services. First

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Microfinance Bank & Khushhali Bank can fill the gaps between the empowerment

opportunities and customers, so this is total concern of my thesis that how and when

First Microfinance Bank & Khushhali Bank can impart their knowledge and role in

microfinance and prosperity of the nation..

1.4 RESEARCH QUESTION

1. What functions, products or services offered by Micro finance institutions in

Pakistan?

2. What are the issues and challenges faced by Micro finance institutions in

Pakistan?

1.5 OBJECTIVES

The main objectives of research include the following;

To make a comparative analysis of the two micro finance banks, which are

The First Micro, finance Bank and Khushhali Bank..

To analyze the functions, products and services offered by The First Micro

finance Bank and Khushhali Bank

To suggest the recommendations to make the working of micro finance banks

more effective

Hypothesis

H0 = First Microfinance Bank & Khushhali Bank activities do not

have any impact on visionary objectives of microfinance and

prosperity of poor segment of country.

H1 = First Microfinance Bank & Khushhali Bank have impact on visionary

objectives of microfinance and prosperity of poor segment of country.

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1.6 SIGNIFICANCE OF THE STUDY

The project is significant in a way that after studying through all the contents

of the research project, the user can effectively judge that how effectively MicroFinancing is being done in Pakistan along with the important issues, problems and

challenges faced by it in Pakistan.

1.7 DELIMITATION

Reliance upon secondary source of information as the data had to be gathered

more from the employees experiences and observations rather than focusing on all

the borrowers from micro finance banks in Pakistan. General overview of micro

finance sector due to unavailability of data in the books, articles or journals as well as

on internet because the topic is more about applied research than basic research.

Difficulty in contacting the staff of The First Micro finance Bank and Khushhali

Bank.

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CHAPTER NO.2

REVIEW OF RELEVAT LITERATURE

Microfinance began as a series of experiments in how to use finance to

empower the poor, and has now evolved into a robust movement and industry. Today,

microcredit for investment (particularly for working capital) remains the sectors core

product, but other financial services such as microsavings and microinsurance are

emerging as powerful complements to loans.

As we observe the recent waves of innovation in microfinance, particularly in

Bangladesh where the Grameen Family of Companies is an especially robust

laboratory for pioneering approaches to social business enterprise, at Grameen

Foundation have begun to talk about microfinance as a platform for multiple

development and business ventures, rather than as a financial product or suite of

products. We stand in awe of what Professor Muhammad Yunus has accomplished

and continue to celebrate his richly deserved Nobel Peace Prize. Furthermore believe

that the collective infrastructure of people, facilities, relationships, and knowledge

that the microfinance movement has amassed can and should be used for more than

provision of financial products.

The potential of microfinance to serve as a platform for launching

complementary approaches to addressing the needs and opportunities facing poor

families, particularly their health and educational attainment, is not obvious to

everyone. I was therefore very pleased when, during my initial conversations withMarge Magnerc via some emails, she immediately grasped the potential of this

paradigm and was one of the most articulate proponents of it I had ever heard. As

arguably the most accomplished female banker in world history, I was eager to have

her go on record with her views since I thought it could influence the dialogue going

on in the microfinance sector about this and related issues. Her roles as a business and

philanthropic leader (who chaired the Citigroup Foundation for many years) make her

uniquely credible and informed on this issue.

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During the course of the research, I interviewed many microfinance

practitioners, including Professor Muhammad Yunus (a few weeks before his Nobel

Peace Prize was announced), Anne Hastings of Fonkoze and Carmen Velasco of Pro

Mujer via emails. I also consulted with business leaders including Ed Scott, the

founder of BEA Systems. Each interviewee articulated their vision of microfinance

and how it can be a platform and network to support social change, and in so doing

shaped this paper. Given time and additional resources we would have talked to many

others who believe in this approach.

If we are going to reach the Millennium Development Goal of halving poverty

by 2015, we will need to not only grow the microfinance movement but also

reimagine it. We see latent and yet unexplored capacities of the network of 113

million poor families currently served by MFIs, and the MFIs themselves, to be a

force in shaping the political economy of the 21st century. We therefore call on

microfinance practitioners, academics, business leaders and others to think and act

with creativity and urgency in leveraging this capacity to accelerate progress.

Our world remains mired in a global poverty crisis. But there is hope. Our

sector has quietly assembled arguably the largest network of poor people in world

history, a network that is touched by the microfinance institutions that serve them on a

weekly basis in most cases. Let Marges words inspire us to seize the opportunities

before us and bring closer to reality Dr. Yunus vision of putting poverty in a

museum as this generations legacy to the next.

2.1 Microfinance in Worlds Eye

The phrase Customer is King may be an oversimplified clich in business,

but stripped of all its bells and whistles this phrase represents the essence of a

consumer business. A businesss survival depends on serving and meeting customer

needs and demands. Businesses have to focus on their customers, their needs, their

behaviors, and a multitude of other factors that impact their lives. A successful,

thriving business can no longer be an isolated business; it must adapt to customers and

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the marketplace. Increasingly, businesses from differing sectors from technology to

entertainment to retail and even to bankingare partnering with each other to cater to

the same customer base or extend their own client access. Today, people can access

banking products and services practically anywhere post offices, online, and

through mobile devices. In addition, financial service providers offer financial

education, consumer awareness, and even training and seminars on managing

personal finances as well as small businesses. Based on this same concept, we believe

that microfinance can better serve its clients by extending services to meet their life

demands.

Over the years, microfinance has demonstrated that its impact goes beyond

providing individuals with access to capital; it has also helped to protect, diversify and

increase their sources of income and assets that enable them to make their way out of

poverty. It has shown that when we provide capital to poor individuals with

entrepreneurial ideas and spirit, they will utilize that capital to generate income for

themselves and their families offering them the potential of a life that is poverty

free. To date, microfinance has touched the lives and communities of more than 100

million families, and has helped lift many of them out of poverty or at least put them

on a pathway to a poverty-free life. However, more than three billion people still live

on less than two dollars a day; more than a billion have no access to electricity; and

three billion have no access to safe sanitation. For these individuals, microfinance is a

tool that must continue to be deployed and leveraged to its maximum potential.

Access to capital has provided people with the opportunity to climb the

economic ladder. Nonetheless, we have witnessed that simple access to capital, while

paramount, is often not enough to realize the kind of rapid poverty reduction that is

needed to reach the Millennium Development Goals. For some, capital is the missing

element in their struggles against poverty. For others, capital is overshadowed by non-

financial factors that also contribute to poverty. Therefore, to create solutions that

address poverty and to enhance the existing use of microfinance, we need to

understand that poverty is a result of a multitude of factors that encompass more than

merely a limited income. According to the Chronic Poverty Research Centre, chronic

poverty is typically characterized not only by low income and assets, but also by

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or $100 in the poorest countries, and somewhat larger ones in middle-income

developing countries, can transform lives.Through microfinance, we have witnessed

those poor individuals, when given the opportunity to start their own business, can

provide for themselves and their family with basic necessities and also generate

sustainable income. If they can maintain that income, it can lead to improved living

standards, and for some, a means to escape poverty. If individuals achieve economic

freedom, it can lead to a series of improvementsimproving the well-being of

families, communities and society-at-large.

The exact benefits that microfinance brings to individuals and society may be

difficult to measure from a technical standpoint, which is why there are relatively few

rigorous studies about impact compared to the reach of microfinance. From studies

and research, however, it is apparent that microfinance is an important catalyst for

poverty alleviation. One such study on two major microfinance institutions, BRAC

and Grameen Bank, found that participants who have continued access to loans have a

lower rate of poverty than those without access, 57 percent compared to 76 percent,

respectively. Another study, by S.R. Khandker, found that the poverty levels in

villages with microfinance programs have declined more than in villages without

these programs. Among program participants who had been members for six

consecutive years, poverty rates declined by more than 20 percent (about 3 percent

per year). Khandker estimated that more than half of this reduction could be directly

attributed to microfinance. He had calculated that microfinance accounted for 40

percent of the entire reduction of moderate poverty in rural Bangladesh.These studies

and numerous othersindicate that microfinance can improve overall income, increase

decision-making power, and provide general self-empowerment.

From its tremendous success as a poverty alleviation tool, microfinance as an

industry has gained momentum and expanded its scope and reach. The awarding of

the Nobel Peace Prize to Muhammad Yunus and the Grameen Bank will only

accelerate its growth. To ensure that the poor not only have access to credit but other

financial services, micro credit has expanded over the years to include a variety of

financial products such as savings, insurance, transfer payments, and even micro-

pensions. Where regulations permit, savings can be a very powerful tool since it

allows the poor to conveniently amass liquid assets that can be used to self-finance

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education, health care, or disaster relief while also giving the MFI a source of capital

for on-lending. Microcredit, or what is now more aptly called microfinance,

attempts to address the multitude of the poors financial needs. With this expansion of

purpose, the field itself has increased its reach. By the end of 2005, according to the

Microcredit Summit Campaign, there were over 3,000 MFIs serving over 112 million

people worldwide, of which more than 82 million were among the poorest people in

the world (i.e., earning less than $1/day) when they became clients.

As the sector has evolved to meet the growing demands for its services, it has

been reinventing itself to ensure sustainability at the institutional level. MFIs and the

organizations that support them have taken lessons learned from the banking sector

and the business world to improve efficiency and sustainability. (Perhaps no

reinvention has been as dramatic and influential as the launch of Grameen II in 2003,

and its rigorous but highly favorable evaluation by SafeSave.) We have witnessed

firsthand MFIs improving their loan disbursement and collection methods in order to

reach more clients faster and better. They are becoming better trained and better run

to meet the growing demands for their services. As the field continues to evolve in its

business model and operations to increase institutional efficiency, it is also critically

important that the field focus on its client success and effectiveness.

2.1.2 Inhibitors to Success

At its core, microfinance is not terribly different from mainstream consumer

finance. From accessing funding to managing the disbursement and collection of

funds, microfinance operates like any consumer finance business. But because

microfinance serves a very different client segment the worlds poor we cannot

ignore the different set of challenges these clients face and the implications these

challenges have on the organizations serving them. Unlike customers of mainstream

consumer finance, who tend to be middle class and live in relatively stable

environments, microfinance customers live under more dire circumstances and

contend with a different set of factors, such as poor health, lack of education and

access to basic necessities, and unexpected threats such as natural disasters that

endanger their everyday lives. Because these factors are so entrenched in their lives,

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we cannot ignore their influence on an individuals economic ability to access, use

and repay a microfinance loan.

Clients may be able to gain access to microfinance and may even start a

business, but they may be unable to convert this credit into sustainable income.

According to one study of three large MFIs in Bangladesh, approximately 5 percent of

microfinance program participants lift their families out of poverty each year. This

finding of impact in particular does bring to our attention that microfinance does not

result in overnight success for many clients; with current product offerings and costs,

progress for most clients appears steady, but slow. In the current models being used, a

certain percentage of clients are never able to generate sufficient profits to completely

escape poverty or even to improve their conditions at the margins. An alarmingly high

percentage drop out (5-30 percent annually in many cases) and many ultra-poor

families never join in the first place (i.e., they self-select out). According to some

studies, it takes 5 to10 years for a poor client to work her way up above the poverty

line, and even longer before she has sufficient productive assets to function

independently from the micro credit institution (although continued participation with

an MFI is not necessarily an indicator of failure on the part of the client or MFI, and

in fact may be correlated with the success of both, in the sense that it may be that

many formerly poor clients continue to have robust investment opportunities and the

MFI has products that are relevant to those opportunities).

What are the factors that hold back microfinance clients from overcoming

poverty more quickly than is currently the case? In other words, why do some people

move out of poverty and others fail to do so or make progress slowly even though

both participate in a microfinance program? In assessing the research and speaking

with numerous practitioners, we identified three elements that diminish microfinance

participants chances for being successful in a program: poor health, natural disasters,

and lack of education. Because the poor live in a state where even the smallest

misfortunes threaten their survival, these three elements are critical factors in

determining the performance of their loans, their progress out of poverty or lack

thereof, and ultimately the long-term sustainability and profitability of the MFI.

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Health

The loss of income due to sickness and incapacitation of a borrower or a

family member, and the high cost of health treatment are detrimental to individuals

and families in the developing world. Therefore, it is not surprising that illness and

death of family members are among the most common reasons why microfinance

participants remain mired in poverty, default on their loans and/or drop out of a

microfinance program. According to a survey of Zakoura Microcredit Program,

problems beyond clients immediate control, which were most frequently an illness or

a death in the family, were the principal cause of client drop out in 28.6 percent of

cases in one sample.In a study of long-term clients of the Grameen Bank by Helen

Todd, ill health was the key factor differentiating those families that had emerged

from poverty and those who had not.

She writes: [A] serious illness in the familyalmost always forced them to liquidate

assets in order to pay for medical treatment and/or keep the family afloat The

disaster of illness struck ten of the 17 Grameen Bank families who are still in the

poverty group, or 50 percent. Among the families who are no longer pooronly 18

percent... [had] been hit with a serious illness.

While the figures above are alarming, they are not surprising. Illness and

injury are common drivers of bankruptcy in the developed world as well. According

to a 2005 study conducted jointly by Harvard Medical School and Harvard Law

School, approximately half of all individuals declaring bankruptcy in the United

States cite illness and medical bills as the primary factors leading to bankruptcy. 12 The

major difference between these two groups (borrowers in developed countries and

microfinance borrowers) is one of vulnerability. For an individual in a developed

country, bankruptcy can be an enormous life challenge leading to significant lifestyle

changes. But developed countries have safety nets and established legal and social

infrastructures such as bankruptcy laws, as well as other public and private

institutions that help people to get re-established and get back onto their feet. In

developing countries, these types of infrastructures and programs either do not exist

or are limited in their reach. Therefore, for a microfinance borrower living on one to

two dollars a day, illness can lead to hunger, deprivation, or even death.

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Natural Disasters

Like ill health, natural disasters are another area of vulnerability for the poor.

Research shows that when disaster strikes, the poor are not only in a greater danger of

falling victim, but suffer disproportionately greater losses. For poor people, the

resulting lost income may force them to sell their land, livestock or their tools, send

their children to work rather than to school, or eat less. Such drastic measures may

mean survival, but they make it much harder for vulnerable households to escape

poverty.13 According to Salvano Briceo, Director of the UN/ISDR Secretariat,

Investing in disaster risk reduction reduces the vulnerability of people to hazards and

helps break the vicious cycle of poverty. We need to engage the microfinance

community into a dialogue on reducing the impact of natural hazards on populations

and livelihoods."

Education

The third critical factor that prevents some borrowers from sustaining a

successful business is lack of education. Most borrowers of microfinance are

incurring debt and operating a business for the first time. And, as we know, the

responsibilities that go along with these two endeavors are great. It requires

understanding the fundamentals of credit and how to manage a complex business.

Without the appropriate support and education, a borrower can find herself unable to

manage a growing business, which can contribute to backsliding into poverty and/or

defaulting on a loan. Providing adult literacy and/or financial literacy modules to

microfinance clients can therefore represent a long-term investment in the well-being

of the client and the MFI that serves them, even if it increases costs in the short run. In

addition, facilitating higher educational attainment among clients children, arguably

a more cost-effective and realistic goal in most cases, can help ensure that at least one

household member involved with the family business is literate, and that a wage-

earning offspring is available to support a client when they reach old age.

Because these three factors, among others, are key impediments to a

borrowers success in the microfinance context, it only makes sense that microfinance

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incorporates some prevention and mitigation measures into its business model.

Improving the health of clients as well as helping the poor to prevent and/or respond

more effectively to these inhibiting factors can contribute to sustainability at both the

client level and the institution level. A healthy client is more capable of managing her

business and generating income for her family. This income generation translates to

an increased ability to make payments on the microfinance loan. This improved

repayment should benefit the lender as much as it does the borrower leading to a

cycle of economic strength for both.

2.2 Microfinance & Pakistan

Pakistan has scarcity of skilled labor force in other vital sectors also, which

could be fulfilled by the huge number of idle but willing work force among the men

and the women in Pakistan. It may be pertinent to mention here, that there is a scope

of 0.3 million additional jobs for women in the garment sector of Pakistan.

The Government of Pakistan and many other developing countries now consider

micro finance as an important component of the country's financial system and

recognize the private sector's role in the poverty reduction strategy.

The sustained commitment exhibited by the government to ensure a conducive

policy environment for the development and growth of the sector has started yielding

results in the form of gradually increasing outreach and the increased investor interest

in the sector. The government is now supporting financial service access to the

majority of the population to advance and provide economic opportunity and access

for the poor, especially, those who work in micro enterprises. Poverty is one of the

few challenges that every single country in the world has to deal with it.According to

the World Bank, 3.0 billion people lived on less than $2 a day in 2006. Despite the

difficulties involved in changing this situation, there are solutions and microfinance is

one of them.

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The Asian Development Bank (ADB) has defined Micro Finance as:

Microfinance is the provision of a broad range of financial services such as

deposits, loans, payment, services, money transfers, and insurance to poor

and low-income households and their micro enterprises.

In Pakistan, Micro Finance is not a new concept. However, after Micro

Finance Ordinance 2001 in for achieving UN Millennium Development Goals

(MDGs), micro Finance culture is now development rapidly. After the government

sector, private sector is also involved in Micro Financing.

The Micro Finance market is now a mature market but it remains too limited

in scale. In Pakistan it has been estimated that about 6.5 million households need

assess to Micro Finance services, while the sector service only 0.5 millions. Over 90%

potential clients are then left out. The concept of Micro Financing is getting more

recognition, especially in countries like Pakistan where majority of the population

needs access to micro financing services. Majority of the population is unaware of

banking services which could be made available to them, but they are unaware of

these services.

In 1960 and 1970, subsidized micro credit was provided in rural areas but it

failed because of unsustainable system. In 1980, Aga Khan Rural Support Programme

was established in northern region to build community based organizations and

infrastructure. Orangi Pilot Project (OPP) was developed to provide individual

lending methodology by targeting entrepreneurs in the region of Karachi. In 1990s

organizations like KASHF, Taraqee and Daman, etc was opened. There scope is

limited because of narrow institutional base, slow progress, sustainability and lack of

efficient benchmarks. Since 2000 many organizations have started their operations

like Pakistan Poverty Alleviation Fund (PPAF), Khushhali Bank, etc. An Ordinance

called as Micro Finance Ordinance 2001 has also been promulgated for efficient

working of micro finance banks and organizations.

The First Micro finance bank is the first bank in the private sector to start

micro financing in Pakistan. According to the World Bank, 3.0 billion people lived on

less than $2 a day in 2006. Despite the difficulties involved in changing this situation,

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there are solutions and microfinance is one of them. Taking all the facts into

consideration, a need arises to see the functions, products and services of micro

finance institutions in Pakistan and to make a comparative analysis between Micro

finance institutions.

2.3 Informal Finance Markets

Informal finance markets (IFMs) have a long history pre-dating formal

markets and a strong presence in most of rural and urban Pakistan. The informal

financial sector is that part of the economy in which financial contracts and

agreements are conducted without official regulation or monitoring.

In one view, these markets exist because financial markets as a whole are

incomplete and with their expansion, informal markets would cease to exist. Another

view maintains that the informal sector does not just exist due to the limitations of the

formal markets but has a comparative advantage in some market segments. Informal

institutions either provide services that formal institutions cannot provide or have a

cost advantage over their formal counterparts. Indeed, some part of the demand for

informal finance comes from the desire to operate outside the formal, documented

economy in order to avoid paying taxes and is sometimes linked to the underground

economy.

However, urban IFMs and small and medium enterprises (SMEs) face

constraints in getting access to institutional credit. Bari and Faheem report for this

study that SMEs are 'credit constrained' in the sense that while they are willing to

borrow and/or borrow more at prevailing interest rates, they do not have access to

funds and thus get credit rationed. Lack of well-functioning financial markets has

disproportionately adverse consequences for the poor who have credit requirements

but few assets that can serve as collateral. They are thus shut out of formal finance

markets and this perpetuates poverty. Richer rural households have better access to

cheaper institutional credit whereas poorer households depend mainly on expensive

informal or non-institutional sources.

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Informal markets cannot be strictly classified. They are generally stand-alone

markets operating without the links that characterize well integrated financial

markets. The multiplicity of informal finance markets is reflected in the observed

diversity of transactions in these markets, such as lending and borrowing among close

relations, rotating saving and credit associations (RoSCAs), moneylending,

interlinked financing and suppliers' credit, among others Urban financial markets are

different from rural ones in certain important respects. Many urban markets catering

to traders, especially wholesalers, have a long history and are quite well developed in

terms of the amounts of funds intermediated, the speed and efficiency of the

intermediation and the sophistication of participants as well as the market as a whole.

Suppliers' credit is a common feature: in old markets with established players,

as much as 90 per cent of transactions are carried out on suppliers' credit resting on

good faith. A chit (parchi) is the norm for making business transactions and is not

dishonoured; it represents a convenient and flexible method that allows business to be

conducted at arms-length and does not require documentation or entail tax liabilities.

Informal finance markets are very common in the transport business. In some urban

areas, moneylenders mostly provide credit in the shape of goods to clients. The annual

interest rate for credit in the shape of goods varies depending on the financial position

of the borrower and his previous track record. Default rates in transport financing are

said to be very low because social linkages help overcome screening and monitoring

problems, reduce the risk of default and ensure availability of multiple channels in

case of repayment problems. Similar patterns were observed in the shoemaking

industry and in the dairy and livestock industry in different cities and different

markets.

2.3Implications For Policymakers And The Microfinance Sector

It is not possible to wish away informal finance markets. Policymakers need to

realize that so long as institutional finance has limited access and does not fully meet

the demands of the client, the informal financial sector will continue to flourish. A

better economic response to the existence of such markets may be to develop more

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their ability to use social collateral or by going into SME lending on their own. In the

first option, MFIs can become information providers to and/or partners of banks and

the second is for MFIs to go directly into SME lending. This option carries higher

risks but promises higher returns as well and implies a significant change in its

organizational structure, client base and priorities. This may not suit MFIs trying to

reach the very poor but could work well for MFIs that fund existing micro and small

businesses. The Pakistan Microfinance Network can take a lead in this initiative and

initiate a dialogue as well as further research their prospects.

2.3Underground Economy

Some transactions in IFMs - especially in urban areas - are linked to the

underground economy, which can be loosely defined as that part of the economy that

goes unrecorded in official statistics and includes activities which are concealed from

the tax authorities in an attempt to evade taxes. Many self-employed persons are

involved in tax evasion and underground economic activities because there is no

formal system of documentation for self-employed persons and their activities. The

Pakistan Institute for Development Economics (PIDE) reports (1998, 2003) show that

the size of this economy has been growing faster than the formal economy and

estimate that it grew from about 20 per cent of the gross domestic product (GDP) in

1973 to 54.5 per cent in 1998 but then declined to 37.25 per cent by 2002. Estimates

of tax evasion show similar trends. The report ascribes the decline to changes in the

overall economic activity, smuggling, documentation of the economy, adoption of the

anti smuggling policy and so on. However, it must be remembered that these

estimates do not yield precise measures but only broad indications of trends.

2.3Size Of The Informal Finance Sector

The informal sector accounts for as much as a quarter of the GDP in certain

countries. In Pakistan, despite the substantial expansion of formal credit institutions,

the predominance of informal rural credit is manifest from its reportedly high share in

total credit extended to the rural population in cash and/or in kind. Clearly,

institutional credit grew in Pakistan during the 1970s and 1980s. On an aggregate, the

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institutional sources which were responsible for about 10 per cent of total borrowing

for all cultivators combined in 1973 rose to account for nearly 40 per cent in 1985,

mostly due to increased lending by the Agriculture Development Bank of Pakistan

(ADBP, now the ZTBL). The importance of borrowing from friends and relatives

among non-institutional sources declined in this period while that of commission

agents and merchants remained about the same. A comparison of the share of

informal rural credit in Asian countries shows that this share is high in all countries,

especially Pakistan.

The share along with the reporting year is: Philippines, 71 per cent (1978);

India, 70 per cent (1972); Bangladesh, 63 per cent (1974); Pakistan, 73 percent

(1985); Malaysia, 62 per cent (1986); Thailand, 52 per cent (1985); Indonesia, 52 per

cent (1985); South Korea, 50 per cent (1981) (World Bank, 1996).

2.3Implications Of IFMS For Poverty

The lack of well-functioning financial markets has disproportionately adverse

consequences for the poor: with credit requirements but few assets that can serve as

collateral, they are shut out of formal finance markets. As a result, the poor have

strictly limited possibilities for consumption smoothing in response to income and

other risks, for financing production enterprises and longer investments through

saving, lending and insurance. Worse still, the severe asset inequalities and lack of

well-functioning financial markets in Pakistan are not offset by access to financial

services which in turn forces the already dependent people to search for security

within the 'moral economy' through the system of patronage and patriarchy. Poverty is

thus perpetuated by further narrowing the ability of the poor to exploit economic

opportunities.

All the available evidence from Pakistan suggests that richer rural households

have better access to cheaper institutional credit whereas poorer households depend

mainly on expensive informal or non institutional sources. This is in line with

international empirical evidence which shows that richer people borrow more and pay

lower rates of interest and that bigger loans are associated with lower rates of interest.

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The National Human Development Report (NHDR, 2003) shows that people below

the poverty line tend to increase consumption by taking loans and selling their assets.

But since their access to credit is limited and they have few assets, they suffer from

extreme nutritional deficiencies and rely on transfers to supplement their incomes.

Furthermore, the NHDR data also shows that the indigent have very high

ratios of loan dependence on landlords and this dependence declines proportionately

for the poor and the non-poor. Absolute levels of indebtedness show a similar pattern

but are generally far higher in the rural areas compared to urban areas when measured

as a percentage of income.

Indeed, this high rate of indebtedness is a major hurdle in poverty alleviation

programmes based on credit alone. The NHDR data shows that most loans in both

urban and rural areas are taken for meeting consumption needs. Since institutional

creditors do not officially provide loans for consumption purposes, the report reveals

that friends and relatives are the major lenders. The Survey of Informal Lenders

(1996), however, states that approximately 90 per cent of the total credit disbursed by

lenders was given for production and investment purposes and that only shopkeepers,

landlords and moneylenders extended some loans for daily consumption. But since

information on the purpose of the loan was provided by lenders, it is possible that the

ultimate use of the credit was not known for certain.

Other surveys show that although farmers are generally able to get informal

loans in times of need, such lending is available only for certain uses (for example,

small consumption loans from friends and relatives) and not for long-term productive

investments (for example, land improvement, land purchase or land leasing). In rural

areas, this is illustrated by data indicating a paucity of fixed-rent leases, which require

upfront rent payment. In an environment where over a third of all cultivated area is

leased out, this is particularly significant, and suggests that the informal credit market

is by no means adequate and bears adverse productivity implications for poor and

landless farmers. The low/no interest loans from friends and relatives are obtained

largely by better-off households. Marginal and small owners and landless tenants have

the bulk of their credit needs met by lenders other than friends and relatives.

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2.3History Of Informal Finance

The indebtedness to informal lenders in the rural areas is not a new

phenomenon. Thorburn (1886) vividly depicted the dominance of moneylenders inthe Punjab. Darling (1925) reported high levels of indebtedness from surveys of

Punjabi proprietors and found that debt was more widespread and deeper in the

Punjab than in the rest of India. He discovered that there were 40,000 moneylenders

in the province, over 80 per cent of Punjabi proprietors were in debt and the average

debt per indebted proprietor was equal to about three years of his net income.

According to his estimates, a large part of the debt was unproductive, being

either compound interest or spent on extravagant expenditures such as marriages and

that only the smallest fraction, almost certainly less than 5 per cent, is due to land

improvement.

Moneylenders have been an integral part of the rural economy since ancient times and

have historically played a vital role in smoothing consumption and financing village

transactions. But with the advent of British rule, the power of moneylenders increased

significantly due to a decline of the earlier vigorous village communities, replacement

of communal ownership of land with individual rights and the establishment of civil

courts which facilitated contract enforcement. Moneylenders further consolidated

their growing power by resorting to widespread malpractices in maintenance of

accounts.

The moneylender ensured repayment primarily through social sanction and

failing that, through civil court decrees. The instrument of mortgage, which became

widespread during the early period of British rule, resulted in massive land transfer

from the landowners to the moneylenders. Out of 742 families examined during an

enquiry by Thorburn in 1896, only in 13 cases did a once involved man recover his

freedom. Thorburn reports that similar conditions prevailed in the NWFP and Sindh

where the big landlords were all deeply encumbered in debt. Such conditions

prompted the British government to intervene with the 'free' operation of IFMs in

pursuance of its political objectives. The British sought to protect the interests of its

loyalist agricultural owners/indebted landlords through the Sindh Encumbered Estates

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Act 1876, and the Punjab Alienation of Lands Act 1900, which prohibited the

purchase and alienation of lands from 'agricultural castes' and thus reduced the threats

to mortgaged lands.

Similarly, during the depression of the 1930s the British protected several

large estates (landholdings) from a change in ownership due to heavy indebtedness

and insolvency owing to the downturn in agricultural prices and rents. In the Punjab,

for instance, protection was sanctioned through The Punjab Relief from Indebtedness

Act 1934. Presently, the money lending business is legally covered under The Punjab

Moneylenders Ordinance 1960 under license from a collector who can also cancel it

in case of forgery, fraud, conviction or excessive interest. But this ordinance is

practically redundant and no records are currently maintained by the revenue

authorities. Some people believe, however, that its repeal will lead to a decrease in the

actual incidence of money lending. Recently, a private bill introduced in the Punjab

Assembly seeks to ban all private money lending.

2.3Providers Of Informal Finance

There are a large number of informal finance markets and each generally

operates singly without the links that characterize well-integrated financial markets.

The multiplicity of IFMs is reflected in the observed diversity of transactions in these

markets: lending and borrowing among close relations, rotating saving and credit

associations (RoSCAs), money lending, interlinked financing, suppliers' credit and so

on. Lending and borrowing among relatives, neighbors, friends and other socially

close lenders is very common for financing needs, especially for consumption-

smoothing purposes. Such transactions have the advantage of being collateral-free

and, in most cases, free of interest as well. These transactions rely on the principle of

reciprocity and represent informal social insurance schemes; both the lender and the

borrower gain from the transaction and the process become self-sustaining.

The borrower is able to finance urgently needed expenditures quickly and with

little transaction costs since there is no lengthy appraisal process involved, little or no

paperwork or travel time and the terms of transactions are well understood. A study of

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the informal sector's role in the NWFP (Integrated Development and Entrepreneurship

Advisory Services [IDEAS] 1999) found the greatest volume of financing came

mostly from friends and relatives. The study found that there is no additional cost or

interest when borrowing from relatives and friends except in some cases where a

profit-sharing arrangement has been made. Shopkeepers are another important source

of lending, especially in rural areas and among low-income households.

While money lending is still a big source of funds for those rationed from

formal finance markets, most moneylenders actually have a different principal

economic activity. This diversification helps them cope better with the risk and

uncertainty in their incomes. Interlinked contracting, another common mode of

informal financial arrangements, usually takes the form of tied credit where the

supply of credit in the form of cash or input supplies is linked to the purchase of the

produced output at a highly discounted price. Money lending and interlinked finance

are discussed in detail later.

In a rotating saving and credit association (RoSCA) or committee, as it is

commonly known, a group of participants puts contributions into a pot that is given to

a single member and this process is repeated over time until each member has had a

turn, with order determined by list, lottery or auction. The member gains demand

deposits, once the saving is committed, but it cannot be drawn immediately and the

member is required to wait his/her turn. The main goal of a RoSCA is to mobilize

savings and channel them to borrowers in some pre-specified order, thus fulfilling an

important intermediation function. In RoSCAs, individuals pool their savings on a

regular basis to generate loan able funds primarily for its members. Not only are the

organizational and monitoring costs very low, default rates by the very nature of

RoSCAs are low as well. RoSCAs exist in almost all developing societies and in some

developed countries as well under different names and have very long lives. But the

essential features of RoSCAs, in terms of a revolving fund for financing lump-sum

expenditure, are similar.

Generally, it usually involves a group of people coming together and

contributing a fixed sum of money after every specified time period. This pot is then

allocated to one of the members of the group. This process continues till every

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member has received the pot. After that the group can disband or start again. There

are a number of ways of allocating the pot (random selection, pre-set order or

auctions) and a number of ways of setting up the group, selecting members and

enforcing discipline. Some RoSCAs even have discounts built into them to take care

of costs for later recipients. But the essential features of the revolving fund carry

across all RoSCAs. For any relationship where payment is made now and repayment

is made over time, the possibility of default is always present. Banks avoid this

through collateral, but committees do not require physical capital as collateral.

RoSCAs work in societies and groups that have strong reciprocity relationships which

allows for the selection of trustworthy members and the avoidance of default.

Moreover, ostracisation in its various forms acts as a sufficient deterrent. If a

society has a very efficient, complete and well-structured financial system, RoSCAs

would not be needed. Banks and other formal sector institutions would then be able

to, in theory, serve all who were willing and able to pay the requisite financial costs.

But the financial system is not complete, has large asymmetries of information and

rations a significant proportion of the population. Under these circumstances,

RoSCAs present one way for these populations to provide for themselves by allowing

people to save and access funds for those buying large consumer items and sometimes

for financing working capital or project finance requirements. From housewives to

businessmen and among the lower and lower middle classes, RoSCAs are a widely

used institution in Pakistan for financing capital expenditures. It is an institution that

'forces' people to save. It performs a dual purpose of credit as well as saving. For

early receivers, it is a credit, i.e., if one has contributed 100 Rs. and has received

1,200 Rs. which he is supposed to repay in interest-free instalments of 100 Rs. per

month. For late receivers, however, it is a saving which somehow or other comes into

the category of compulsory saving The method lacks any intervention of the

formal credit and saving institutions. A small saver does not have to hide the cash at

home or to deposit it with some relative for safety. Another advantage may be the

availability of the interest-free credit for the early receiver, which is hardly available

in any other method.

The receivers may also exchange their turns through mutual consent if

someone needs the money immediately, (Waheed, 1996). Auction RoSCAs, on the

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other hand, involve fairly complex dynamic auctions and the bidding system outcome

is often lending at a market-determined interest rate. As a part of this study, several

auction based committees were observed in different markets. One of these was an

auction-based committee of 125,000 rupees with 125 members each contributing

1,000 per month. In the month observed, the committee was auctioned for 61,500

rupees leaving a saving of 63,500 rupees. This saving was added to the savings from

the previous month, which equaled 32,500 rupees, and then a second committee of

96,000 rupees was auctioned. This second-round committee was bid for 63,000 rupees

and the saved amount of 33,000 rupees was carried forward to the next month. The

process continues till all members receive a committee. In some markets, committees

are only operated during the peak season.

In a survey conducted for this study in the urban markets of Lahore, RoSCAs

were a fairly common phenomenon. (However, committees as a means of financing

business were found to be unsuccessful in some markets due to high default rates

caused by weak contract enforcement once defaulters began using court injunctions or

stay orders to stop paying.) Similar findings were observed in other markets in

Peshawar, Karachi and elsewhere and some markets still have auction based

committees. Most of the respondents reported that women from their households were

also participating in RoSCAs for household needs, although these involved much

smaller amounts.

2.3Urban Finance

The informal sector refers to economic activities that are organised outside the

penumbra of the state's judicial and administrative machinery. In the absence of state-

provided institutional infrastructure, agents in the informal markets often devise or

adapt institutional mechanisms to reduce their costs of transacting. It generally

includes a vast and heterogeneous array of small-scale, family-based, unregistered,

petty trades and casual labour activities that are marked by relative ease of entry,

flexible structure and hours of operation, simple and relatively labour intensive

technologies, and low formal skills.

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Often regarded as a kind of fallback, the informal sector acts as a cushion or a

social safety net that provides employment to those unable to get jobs in the formal

sector. Another view stresses its positive role in providing employment and incomes

as well as its potential role as a source of productivity leading to economic

development. There is wide agreement that SMEs play a vital role in the structural

transformation from low to middle income levels and in providing employment and

output in the early and middle stages of the transformation. But this does not appear to

be the case in Pakistan. In Pakistan the SME sector has acted neither as a significant

engine of growth, nor as an important conduit for structural change. Judging from

international experience, Pakistan might represent a case where the potential of SMEs

has not been adequately exploited (World Bank, 2003).

Owing to mass urbanization - especially the proliferation of peri-urban areas

and development of major urban systems - and the inability of the formal sector to

cater to the needs for settlements, employment and service delivery, the informal

sector seems to have mushroomed in Pakistan in recent decades. Nonetheless, various

studies indicate that its growth is seriously constrained by low access to capital which

is exacerbated by its non-legal and unregulated status, lack of authorized business

locations, collateral requirements and perceived risk of operation. Indeed, a majority

of establishments in the non-agricultural sector are micro-enterprises. In the Punjab

alone, the private sector provides close to nine-tenths of total employment while an

overwhelming share of private sector employees work in units with less than 10

employees. Thus the livelihood of the majority of the population depends

overwhelmingly on the small enterprises, particularly in the informal sector. This

highlights the fact that poverty reduction is closely linked to improving productivity.

Urban financial markets are different from rural ones in certain important

respects. The former are characterized by closer proximity and greater mobility of the

participants which has implications for information flows and socio-economic

dynamics. Players in urban markets also tend to be wealthier, resulting in a greater

ability to bear risks and to offer tangible collateral. The rural and urban financial

markets are also marked by an asymmetry: a borrower and lender in an urban market

today may be in the reverse situation tomorrow but, in rural IFMs, lenders and

borrowers have generally distinct identities and the same individual is the principal or

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agent in all repeated transactions. The nature of power relations among the respective

participants is also different in rural and urban IFMs. Many urban markets catering to

traders, especially wholesalers, have a long history and are quite well developed in

terms of the amounts of funds intermediated, the speed and efficiency of the

intermediation, and the sophistication of participants as well as the market as a whole.

The larger of these markets also set interest rates and the terms of transactions which

are then followed by the smaller and relatively less-developed markets.

A common feature of all urban markets is suppliers' credit, with as much as 90

per cent of transactions in old markets with established players. Its prevalance is

attributed to liquidity constraints and the avoidance of handling cash and tax

documentation. There is generally a two to four percent discount built in for cash

payments. Richer parties often have the advantage - a symptom of class segmentation

- because they are able to get better prices on cash as well as better deals even on

supplier' credit. Meanwhile, immediate financing was also found to be available in

urban IFMs through moneylenders on personal guarantees. In many markets, a chitor

parchi is the norm for making business transactions and is seldom dishonoured. This

system represents a convenient and flexible method that allows business to be

conducted at doorsteps without the hassle of documentation or tax liabilities. It was

found that most businessmen maintained their accounts through chits, partly due to

the lack of skills for maintaining a modern accounting system but also because of a

fear of tax authorities. Most shopkeepers privately admitted that tax evasion is a

common phenomenon which is why a large number of businessmen maintain double

accounts: there is a margin between cash and credit sale which varies from party to

party as well as duration.

The role of market associations, according to most respondents, was very

crucial. These associations not only help mediate disputes through moral persuasion

and social pressure or boycott but create a congenial atmosphere in which to conduct

business through collective action - a significant function since honour and personal

guarantees rather than written contracts are the custom. In a study of Delhi's urban

markets, Srivastava (1990) reports: participants in these markets often have access to

diverse institutions, such as market-wide organized associations that can create,

maintain, and enforce complex contractual mechanisms that lower costs of transacting

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for individuals. A general rule followed by many market associations is that when a

defaulter approaches any shop for a business transaction (generally to sell his

product), the shopkeeper is obligated to pay the defaulted party. The respondents also

felt that in markets where associations are not as strong, there tended to be far more

instances of fraud either through reneging on contracts or by supplying low-quality

goods.

Transactions in wholesale markets are facilitated by the fact that many traders

have had their business handed down to them through the generations and they thus

have links across the markets as well as the country. In most of these markets, the

risks associated with arms-length transactions have been countered through

institutional innovations and human contact and trust. The fact that such markets are

dominated by certain business families such as the Sheikhs helps build trust (signaling

effect) through informational advantages from social flows and personal relations.

Most respondents said that they interact with their business partners socially as well

and they would trust a partner more if he were from the same community or if they

had greater interaction with him.

Although such social interaction helps gather information needed for

conducting business transactions, it also acts as a barrier to the entry of new players.

In certain IFMs, there are fairly well-functioning forward markets that link input

suppliers, manufacturers and wholesale traders. The shoemaking industry was

observed in different cities and different markets in Charsadda, Lahore, and Karachi.

In the shoe market of Shah Alami, Lahore, for instance, small manufacturers who

supply shoes to the wholesalers get IOUs which can be redeemed after one month.

Since these manufacturers need working capital to purchase inputs but their liquidity

constraint means that they cannot wait for a month to be repaid, they approach a

secondary market in Shah Alami to redeem the IOU for cash at a discount of 10 per

cent. Thus an IOU pledging a payment of 10,000 rupees is redeemed for 9,000 rupees

in the same market. Similar practices were also observed in Karachi.

In markets with a large number of new players, however, business is largely

conducted in cash since the default rate is very high and sale on credit is only done

with trustworthy parties. This makes it difficult for newcomers to break in and acts as

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a barrier to entry. Most of the shopkeepers involved in the wholesale and retail

business were members of RoSCAs while the small, informal producers were mostly

engaged in seasonal RoSCAs. When interviewed, all the small informal producers

responded that access to credit at market rates would help them make more profit and

expand their business since it would enable them to purchase inputs on cash at better

prices and to run their production cycle more efficiently.

Meanwhile, the textile business is facilitated by the presence of brokers and

investors at every stage - from cultivation to processing, manufacturing and finishing.

These brokers mainly act as a liaison between the concerned parties and charge a

commission. In terms of enforcement of contracts, in Faisalabad for example, the

broker receives a slip from the weaver and pays the spinner. This slip is equivalent to

any cheque or bank draft. This 'trust' has developed because of repeat transactions

since everyone knows everyone and no one can participate without a reference.

Everyone also knows the scale on which the concerned parties are working and their

reputation in the market. Firms have to make their payments on time because if they

do not, no one would be willing to work with them and they would soon be cold

shouldered. A mapping of IFMs in the textile sector was carried out by the Punjab

Economic Research Institute (PERI) for this study.

In the transport business as well, informal finance markets are quite common.

In some urban areas, moneylenders mostly provide credit in the shape of goods - in

these case vehicles - to clients. The registration of the vehicle remains in the name of

the lender until the client pays the entire amount with interest. Lending through

vehicles is popular due to the ease of impounding in case of default. The annual

interest rate for credit in the shape of goods varies on the financial position of the

borrower and his previous track record. The most widespread value of monthly

installments is 5,000 rupees per month for every 100,000 rupees.

Interviews with three major financiers hailing from the tribal areas of the

NWFP in the transport business revealed that they considered lending on interest to be

un-Islamic, but regarded commodity and transport financing as legitimate. According

to them, more than 90 per cent of commercial vehicles (mostly trucks) were operating

on the installment system with repayment durations averaging between five and eight

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years and with a gross mark-up over total financing (current price minus down

payment) ranging from 50 per cent to 100 per cent, depending on the level and

number of installments. A second-hand truck costing 1.6 million rupees, for example,

was observed to be sold with a 200,000-rupee down payment for 2.4 million rupees

(carrying a gross mark-up of one million rupees) with installments mutually agreed at

40,000 rupees per month. Normally, since the lenders are more concerned with cash

flows, the interest rate does not explicitly enter the contract. Interest is instead implied

in the contract, which only shows the actual cost of vehicle, the profit margin of the

lender and the number of installments. Thus a loan of one million rupees in the shape

of a vehicle may carry an interest rate of 20 per cent if the repayment period is one

year and 30 per cent if it is two years.

Default rates in transport financing were said to be very low. In their personal

experience, the respondents said that they had witnessed only eight to 10 cases of

default out of hundreds of transactions. In case the borrower-owner wants to sell the

vehicle, he usually introduces a prospective buyer to the financier. The prospective

buyer then arranges a guarantor to the satisfaction of the financier and a deal is struck

between all the parties on the outstanding transactions. Similar financing patterns

were observed in the tyre business where the turnovers are much faster although the

margins are lower. The financiers largely hail from the NWFP or the tribal areas and

the borrowers are also mostly from the same community.

The social linkages thus help overcome screening and monitoring problems,

reduce the risk of default and ensure availability of multiple channels in case of

repayment problems. Transport financing on installments is also available at many

places in Lahore. Some financiers now resort to insuring vehicles while many drivers

who worked earlier on a daily-wage basis now get their own vehicles. However, while

the easy availability of vehicle financing and leasing has mostly ended informal

lending in new cars, it is still done for second-hand vehicles. The terms of agreement

differ with each party. In each market, brokers act as middlemen who also offer a

commission to the potential borrower/buyer if he is acting as the agent of another

party (a case of principal-agent divergence of interests). The higher the installment the

lower the interest charged: if the installment goes up to 8,000 rupees, for instance, the

interest charged goes down to 20 per cent. Needless to say that a client with a good

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past history is offered better terms. A default of two or three installments means that

the vehicle is seized and then either a revised contract is worked out with the old

owner or it is sold and the new purchaser and the old owners then share the loan. In

the dairy and livestock sector, traders advance credit to the buffalo owners and in turn

exercise a right to the produce from the animals and charge a commission over it.

In case of default, the issue is adjudicated by a panchayat. In Karachi, for

example, a group of six buffaloes costing 180,000 rupees was sold for 250,000 rupees

on installments to be repaid within six months. The extensive prevalence of urban

informal lending was confirmed by the Survey of Informal Lenders (1996) which

found that except landlords and shopkeepers, most informal lenders were

concentrated in towns which they used as bases to extend their operations to

surrounding villages. It reported that on average, the business of commission agents

was spread over 19 villages, while that of moneylenders and landlords over two

villages each.

2.3Informal Savings

While savings are needed by all households for smoothing income and

consumption flows, they are especially vital for the poor. Being excluded from the

formal credit markets, they need savings to mitigate risk and make productive

investments in their farms or informal enterprises. The poor save in a variety of

financial and non-financial forms: farmers save at harvest time to get through the pre-

harvest lean season. Similarly entrepreneurs with businesses that have high and low

seasons save for the low seasons during the high seasons. Many of the poverty-

stricken count everything except basic necessities as excess liquidity in order to save

for emergencies, investment opportunities, social and religious obligations, children's

education, and other purposes. The primary need of low-income savers is to swap

small savings flows for lump sums needed for a variety of purposes (Rutherford,

2000). Entrepreneurs also save in the form of raw materials needed for enterprise,

finished goods, by stockpiling construction materials, other liquid assets, or by saving

in cash, gold and land.

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The Committee on Rural Finance (2003) suggests that savings in Pakistan -

although small because of a low national savings rate compared with countries at a

similar stage of development - are available in the rural areas but are not being tapped

due to the lack of institutional channels such as banks for savings in the rural areas. It

reported that rural areas contribute about 20 per cent of total bank deposits, but these

are largely used for lending in urban areas. As a result, people in rural areas invest

their savings largely in livestock. Livestock can be bought and sold when needed and

is a good livelihood diversification strategy for low-income households. It helps

supplement their income through sale of milk and milk products and their

consumption as a food supplement as well as reduces their dependence on a seasonal

income through the harvest yields of crop products. Livestock keeping also acts as an

insurance against unanticipated events and social ceremonies. The International Food

Programme Research Institute

(IFPRI) Rural Survey of Pakistan (1996/97 to 1998/99) shows a strong and positive

correlation between ownership of buffaloes and household income. Goats and sheep

are another form of saving that is more popular with women. Livestock is also kept

through share leasing, a saving arrangement between landlords and the professional

strata orkammis.

However saving through livestock is vulnerable to a number of uncertainties

and hazards. Another traditional saving arrangement is the reciprocal exchange of

cash, kind and favors called vartan bhanji in the Punjab. This is an account of cash

and kind in a household that has been deposited by another family to help them on

certain occasions and is later withdrawn on similar occasions from the depositor's

household. Another such arrangement in rural Punjab is called wanghar, which means

asking others for help on a voluntary and reciprocal basis. Here, a household helps

another household in need of excess labour: wanghar is normally arranged for

seasonal activities requiring extra hands such as sowing, harvesting, threshing,

building sheds orderas and so on. Hoarding gold and silver is also common in rural

and semi-urban areas. Mothers start saving small amounts of jewellery for the

marriage of their children, especially daughters. Traditionally such jewellery is

supposed to be retained for a lifetime and transferred to the children, to be utilised

only as a last resort through sale or mortgage. Lately migrant workers from the

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Middle East have also been bringing home stamped pieces of gold - to be sold in case

of need - and hence performing a saving function.

2.3Informal Transfers

Informal transfers are an exchange between households of cash, food,

clothing, loans and other informal assistance. Such transfers help smooth the

consumption of receiving households. These also impact publicly funded social

protection programmes through a private compensatory response to public

interventions. Empirical evidence suggests that the bulk of informal transfers flow

from older to younger households, poor and vulnerable households are more likely to

receive private transfers while non-poor households are more likely to give private

transfers and female-headed households appear to be more likely to receive them.

While informal transfers do indeed help the poor in risk management, they are not

adequate substitutes for public action in social protection. Public intervention is also

needed when income shocks are covariant, delivery mechanisms are costly, the

severity of the income shock is extraordinary and when shocks are repeated.

A popular informal system of transferring money around the world is hawala .

It originated in the Middle Ages for financing trade but is currently popular among

migrants from Pakistan and other South Asian countries as a speedy mechanism for

sending remittances back home while bypassing banks. It has some advantages over

formal banking operations since it is marked by low commissions, fast transactions,

little documentation with no identification required and round-the-clock operation.

The system works through individual brokers or operators collecting funds at one end

of the payment chain and others distributing the funds at the opposite end. For

example, an expatriate working in USA, Europe or the Middle East, who wants to

send money back to his family in Pakistan, gives the money to a moneylender or

trader with contacts in both countries. The trader calls a trusted partner in the home

country who delivers the amount to the family, minus a commission. For

identification and the details of the trade, a code is often used. The two traders settle

accounts either through reciprocal remittances, trade invoice manipulations, gold and

precious gem smuggling, the conventional banking system, physical movement of

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currency, or by reverse hawala. Hawala markets are characterised by strong market

segmentation.

Thus it has been observed that ethnic communities generally trust and deal

only with hawaladars who belong to theirbiraderi or community. While it is illegal

in many countries, even central or commercial banks make use of the system.

Anecdotal evidence suggested that most moneychangers currently operate through

Dubai. Usually, hawaladars operate independently of each other rather than as part of

a larger organization and are generally merchants or small business owners who

operate hawala activities alongside their normal business.

However, what makes the system attractive to expatriates and migrant workers

also makes it equally compelling for drug traffickers and terrorists. A report estimates

that 3,000 international hawaladars operate in Asia with an estimated annual volume

of 200 billion US dollars (Beate Reszat, 2002). The hawala system has gained

prominence following the 9/11 attacks in the US as a major medium for money-

laundering, financial crimes and financing of criminal and terrorist organisations.

Pakistan has taken a number of steps to check this practice, including Prudential

Regulations XI and XII to prevent the criminal use of banking channels for the

purpose of money-laundering and so on; the Control of Narcotics Substances Act

1997 with special attention to unusual transactions, illicit narcotics activities and a

penalty for failure to report; and the National

Accountability Law, section 20, which requires banks to report unusual or large

transactions.

2.3Rural Finance

In rural areas, despite the expansion of institutional and policy directed credit,

informal markets still supply most of the credit needed by the low-income segment of

society. A high concentration of the banking sector in urban areas, especially big

cities, and its primary focus on servicing urban and industrial needs leaves limited

financial channels available to the rural poor and small farmers who then resort to

informal means of savings and credit. Such credit is mostly supplied by aartis or

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commission agents and other middlemen at high interest rates through interlinked

transactions. The acute shortage of capital at affordable rates severely

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