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.


Title Page………………………………………………………………………    i

Certification……………………………………………………………………    ii

Dedication……………………………………………………………………..    iii

Acknowledgement…………………………………………………………….    iv

Abstract……………………………………………………………………….    v

Table of Contents…………………………………………………………….    ix       

List of Tables…………………………………………………………………    xi

List of Figures………………………………………………………………..    x

Acronyms…………………………………………………………………….    xii

1.0    CHAPTER ONE                      INTRODUCTION

1.1    Background of the Study                            1   

1.2    Problem Statement                                4

1.3    Objectives of the Study                             6

1.4    Research Hypotheses                                7

1.5    Justification of the study                            7

2.0    CHAPTER TWO         LITERATURE REVIEW               

2.1    Theoretical Framework        9   

2.1.1    Theory of Vicious Circle of Poverty                        9

2.1.2    Theory of Imperfect Information                         10

2.1.3    Theory of Transaction Costs                            11

2.1.4    Complementary Hypothesis                             12

2.2.0    Conceptual Framework                              13

2.2.1    Financial Development and Economic Growth                13

2.2.2    The Structure of the Nigeria Financial System                14

2.2.3    Small Enterprise Financing: Problems and Constraints            19

2.2.4    Features of Financial Institutions and Reasons for linkages            22

2.2.5    Meaning, Examples and objectives of Linkages                 24

2.2.6    Linkages and Policy                                 26

2.2.7    Concept of Linkage Banking                             28

2.2.8    Factors of Effective Linkages                         33

2.2.9    Roles of Different Financial Sectors in Linkage                 35

2.2.10    Categories of Linkages                            37

2.2.11    Linkage Model                                 37

2.2.12    Linkage Motivation                                                         45   

2.2.13    Contracting Mechanics of Linkage                         46

2.2.14    Outcome/Impact of Linkages                            47

2.2.15    Financial System Development and Potential for Linkages            50

2.2.16    Constraints to Linkages                            50

2.2.17    Strategies for Linkages of Financial Institution                 52

2.2.18    Institutional Adjustments for Linkages                     56

2.3    Empirical Framework                                57

2.4    Analytical Framework                                58

2.4.1    Binary Response Model (Probit Model)                    58

2.4.2    Exploratory Factor Analysis                            60

2.5    Summary of Literature Review                            64   

CHAPTER THREE        METHODOLOGY               

3.1    The Study Area                                66

3.2     Sampling procedure/Sample Size                         66

3.3      Data Collection                                67

3.4.0   Data Analysis                                     67

3.4.1    Model Specification                                   68

3.5      A Priori Expectation                                76


4.1.0    Financial Institutions in the Study Area                    77   

4.1.1    Formal Financial Institutions                            77

4.1.2    Informal Financial Institutions                        78

4.2.0    Operations of  Financial Institutions                                79

4.2.1    Operation of the Formal Financial Institutions                  79

4.2.2    Operations of Informal Financial Institutions                    82

4.2.3    Areas of Linkages between Formal and Informal Financial Institutions    87   

4.3.    Institutional Factors that facilitate Linkages between Formal and         91

             Informal Financial Institutions                       

4.4    Constraints to Linkages between Formal and Informal Financial         95


4.4.1    Major Constraints to Linkages between Formal and Informal Financial    97


4.4.2    Result of test of difference on Constraints to Linkages between Formal

 and Informal Financial Institutions.                         103

4.5    Strategies for Facilitating Linkages between formal and Informal         105

Financial Institutions

4.5.1    Results of test of difference on Strategies in Facilitating Linkages

between the Formal and Informal Financial Institutions            109

4.5.2    Ranking of Strategies                                109

4.5.3    Major Strategies in Facilitating Linkages between formal and

Informal Financial Institutions                        111


5.0    Summary, Recommendation and Conclusion                    117

5.1    Summary                                    117

5.2    Recommendations                                122

5.3    Conclusion                                    123

5.4    Suggestions for Further Research                        124

5.5    Limitations of the Study                            124

References                                            125   

Appendix I:    Questionnaire for Formal Financial Institution                133

Appendix II:    Question for Informal Financial Institution                     144

Appendix III:     Mean and Standard Deviation of Formal and Informal             156

Financial Institution Institutions on Constraints to Linkages            158

Appendix IV:     Results of Varimax Rotated Constraints to Linkages by Informal        

Financial Institutions                                 160

Appendix V:    Result of Varimax Rotated Constraints to Linkages by Informal       

        Financial Institutions                                162

Appendix VI:    Result of Test of Difference on Constraints to Linkages

between Formal and Informal Financial Institutions                 164

Appendix VII:    Mean, Standard deviation and t-test Analysis of Formal

and informal Financial Institutions on Strategies for Facilitating Linkages   168

Appendix VIII: Rotated Component Matrix  of Informal Financial     Institutions on

Strategies for   Linkages with the Informal Sector                170

Appendix IX:    Rotated Component Matrix of Informal Financial Institution on         171

Strategies for Linkages with the Formal Sector



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

to the funding of  enterprises (Miller and Berry, 2005). The concept of linkage is a financial reforms, or structural adjustment that may help expand formal credit to the informal sector in the hope that this will improve loan terms for borrowers who are shut out of the formal sector.  

For the purpose of this work, financial linkage is defined as any mutually beneficial integration or partnership; a joint venture between a formal and an informal financial institution that may result in the expansion of financial services. Operationally, a formal financial institution such as a bank is said to be linked to an informal financial institution  (Self-Help Group) where the bank provides financial support  (credit)  to the Self-Help Group. A Self Help Group such as “Isusu” collectors may  be linked to a bank through  deposits.  A bank and Self Help Groups (Isusu) are considered linked where “Isusu” clerks are employed by banks to operate as saving collectors for the bank.   An informal financial institution (Isusu collectors) is said to be linked to a formal institution where  “Isusu” collectors take loans from banks  for  lending to her own clients; where  Self Help Promotion Institute (SHPI) accepts the contractual responsibility for the repayment of members’ loan to the bank; where Self-help Group (SHG) assists banks to monitor, supervise and recover bank loans. In all these cases, there is the flow of funds and services between these sectors. This forms part of a complex system of credit-layering that exist to deal with the problems of information gathering, monitoring, collateral, and the enforcement of repayment. In this sense the two sectors are complementary.

Banks in this partnership come in as shareholders with considerable financial resources. They bring in technical expertise in the proper management of the finances and the keeping of sound records of transactions. Informal agents as shareholders bring into the management, information about the potential clients otherwise unavailable to banks. As agents, they also establish direct links with clients in order to enhance outreach through social networks, facilitate savings, provide credit delivery, increase repayment rates, develop practical and efficient ways of increasing access to credit. Such mutual reinforcement that is based on comparative advantage will lead to economic development (Harper and Singh, 2005).

UN (1984) resolved that both formal and informal financial institutions are necessary for financing development and that linkages between them seem to be more promising than separate existence. The capacity of the financial systems could be enhanced if integrative mechanism between these sectors are developed as this may  reduce operational constraints facing each other and at the same time capitalize on the comparative advantages conferred by each sector (Nissanke and Aryeetey, 1998). Even though markets incorporate both formal and informal sectors, the system could perform its functions more efficiently if the potential benefits from specialization of each other sector could be properly exploited through linkage.

1.2    Statement of the Problem           

Business exploitation, expansion and modernization depend on capital investment, given good management. Most business people in developing nations are poor and so require credit. Providing credit to poor borrowers has remained a challenge; as credit markets in these regions are faced with the problem of enforcement and imperfect information among others (Seibel, 2001). Government intervention in the form of ownership of banks, regulation and subsidization of credit has equally failed to allocate credit to poor borrowers (Udry, 1994). Institutional problems such as the lending conditions which limit access of investors to credit facilities have not been adequately addressed (Vargese, 2005). The fragmented structure of financial institutions where formal and informal sectors operate almost independent of each other is inimical to the growth of a strong and sustainable financial system (Bagachwa, 1995).    

The formal financial institutions have extensive infrastructures and system, strong management capacity, access to  funds, yet they are further removed from rural investors making obtaining adequate information and enforcing contracts imperfect and costly (Yaron 1997). In the absence of information for instance, on the informal sectors’ ability to repay loans, the formal sectors shy away from partnership or linkages.

In contrast, informal financial institutions which operate close to rural borrowers possess enforcement mechanisms, have acceptable credit programmes, low cost of transaction, cheap outreach and good information about borrowers, but they do not provide enough credit to investors, neither have they linked borrowers to the mainstream financial sector as a result of institutional factors (Floro and Yotopoulos, 1991). Linkage arrangement will help address the information asymmetries, resolve enforcement problems, reduce cost of transaction, improve financial service delivery and hence facilitate economic development.

As micro enterprise expand in size, the volume of loan investors require becomes increasingly difficult for the informal institutions to satisfy, yet they still remain too small for the formal lenders (Aryeetey, 1997). The above scenario underscores the importance of linkage as an approach that may help pool together for sharing the respective comparative advantages of the different financial sectors. The informal sector brings to bear critical information on the creditworthiness of potential borrowers and relationship with the community that can promote timely repayment. The formal sector meanwhile can offer considerably more funds for lending than the informal lenders –a symbiotic relationship..

    Legal and regulatory systems as well as property rights in many developing nations including Nigeria are unclear and often difficult to enforce making it hard for financial institutions to link up with each other. Lack of confidence among market players, poor capacity building especially of the informal sector and institutional rigidities on the part of formal sector have all militated against linkages between financial sectors.

Some studies on linkages between sectors have gaps. For instance, Alam (1989) studied areas of linkages between financial institutions in Bangladesh without the factors that facilitate such linkages.

 Phelps (1995) reported on areas of linkages between sectors, leaving the constraints and strategies that facilitate such linkages. Ohabughiro (1998) and ODI (2000) in Ghana outlined conditions for linkages without strategies that will encourage effective linkages between these institutions.

    This work intends to fill the above gaps by identifying areas of linkages between formal and informal financial institutions, factors that facilitate such linkages, major constraints to linkages and institutional reforms that will enhance linkages between formal and informal financial institutions in south eastern Nigeria. The basic thesis of this study is that most investors in Nigeria are poor and require credit either for initial business establishment, for business expansion or modernization.. They source for fund from both formal and informal financial institutions. These institutions have their respective strengths and weaknesses, and on their separate existence will not satisfy the credit needs of borrowers (Gallardo, Randhawa, 2005). The study is of the view that  effective linkages between formal and Informal Institution remains a strategy that will help expand formal credit to informal lenders, in the hope that this will improve loan terms for borrowers who are shut out of the formal sectors.             

1.3    Objectives of the Study 

The broad objective of this work is to examine the linkages between formal and informal financial institutions in South Eastern Nigeria.

The specific objectives of the study are to:

(i)    identify the financial institutions in the study area and describe the operations of the formal and informal financial institutions;

(ii)    identify areas that formal and informal financial institutions are linked, and the institutional factors that facilitate such linkages;

(iii)    determine major constraints to linkages between formal and informal financial institutions;

(iv)    determine major strategies or institutional reforms that would enhance linkages between

formal and   informal financial institutions;

(v)        make recommendations for policy and further research based on findings.

1.4    Research Hypotheses  

The following two null hypotheses were tested:

i.    Institutional factors do not facilitate linkages between formal and informal financial institutions,

ii.    The perceptions of the formal and informal institutions on constraints to linkages and strategies that would facilitate linkages are not statistically different.

1.5    Justification of the Study

The financial services industry is fragmented with little or no integration or overlap between the various sectors (SANMFI, 1998). Each of these sectors has her strengths and weaknesses and so their linkage or integration will present important synergy that can help the whole system to efficiently intermediate financial services to investors, especially those who are locked into a “production-credit” cycle.

The credit market in Nigeria, as in other developing nations, have much weaknesses and steps must be taken to restructure them to improve their viability (Seibel 2001). One way to achieve this is to encourage linkages between the sectors. Improvement in the financial sector is still seen as crucial to reduce poverty and limited economic opportunities. Developing effective principles or framework for linkage arrangement may make fund more accessible to investors, thereby promoting enterprise development. Linkage arrangement will open channels of communication, create common fora for the exchange of ideas and information; make for joint planning and coordination; develop practical and effective ways  for financial capacity building thereby reducing constraints of economic

 activities. It may help design government policies that will be attentive to market limitations; introduce structural reforms that may facilitate investors’ access to credit (ODI, 2000).

The study is further justified because its findings and recommendations will be of  benefit to  the following stakeholders; researchers, policy makers, operators of credit scheme. To the researcher, for instance, it will serve as a reference point, database or benchmark for further studies. The study will help financial institutions to evolve structural and operational adjustment mechanisms for a better way of channeling credit in terms of volume and time with better repayment rates. Policy can be formulated to address issues relating to training and capacity building for financial intermediaries. Effective linkages will help financial institutions to fully utilize existing institutional resources (Johnson, 2001).

The informal financial institutions are important sources of financial relief for most borrowers. The small volume of savings they have do not afford the sector enough loans to borrowers. If these informal sources are to be relied upon in far-reaching rural development processes, they must not be allowed to operate completely outside the formal financial sector (Nweze, 1994).  Combining the bank’s capital with the intrinsic advantages of the informal agents’ such as good knowledge of borrowers, small savings and loan provision, physical and social access, simple procedures, reliance on social capital and collateral, quick withdrawal and disbursement is thus a justification for linking the formal and informal financial intermediaries.




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