Credit, Formal & Informal Sectors, and Self-Help Groups

NCERT Understanding Economic Development | Chapter 3: Money and Credit

Two Different Credit Situations

A large number of everyday transactions involve credit^? in some form. Credit (or a loan) is an agreement in which the lender provides the borrower with money, goods, or services in return for a promise of future payment. However, the outcome of credit depends heavily on the circumstances of the borrower. Let us examine two contrasting situations.

What Are the Terms of Credit — Interest Rate, Collateral and Documentation

Every loan agreement specifies an interest rate that the borrower must pay to the lender along with repayment of the principal amount. In addition, lenders may demand collateral^? (security) against loans.

The interest rate, collateral and documentation requirements, and the mode of repayment together comprise what is called the terms of credit^?. These terms can vary substantially from one credit arrangement to another, depending on the nature of the lender and the borrower.

Example: A Housing Loan

Consider Megha, who takes a loan of Rs 5 lakhs from a bank to purchase a house. The annual interest rate is 12 per cent, and the loan is to be repaid over 10 years in monthly instalments. Megha had to submit employment records and salary documents. The bank kept the papers of the new house as collateral, to be returned only after the entire loan with interest is repaid.

Variety of Credit Arrangements — A Village Example

Credit arrangements vary enormously depending on who provides the loan and who borrows it. Consider the village of Sonpur, where different residents access credit from very different sources and on very different terms.

Notice the stark differences: Arun, who has land as collateral, gets a bank loan at 8.5% per year. Shyamal, a small farmer, borrows from a trader at 36% per year and must sell his crop at a low price. Rama, a landless labourer, borrows at 60% per year and repays through her labour, caught in a worsening debt cycle.

Cooperatives as a Source of Credit

Besides banks, cooperative societies are another major source of affordable credit in rural areas. Members of a cooperative pool their resources for mutual benefit. For example, Krishak Cooperative, near Sonpur, has 2,300 farmer members. It accepts deposits from members, uses these as collateral to obtain bank loans, and then provides credit to members for agricultural inputs, housing, fishery, and other needs.

How Does Formal Sector Credit Work — Banks and RBI Supervision

The various types of loans can be grouped into two broad categories: formal sector^? loans and informal sector^? loans.

The Reserve Bank of India supervises the functioning of formal sources of loans. It monitors whether banks maintain adequate cash reserves, ensures that lending is directed not just to profitable businesses but also to small cultivators, small-scale industries, and small borrowers. Banks must periodically report to the RBI on their lending activities, interest rates, and categories of borrowers.

No such oversight exists for the informal sector. Informal lenders can charge whatever interest they wish and there is no mechanism to prevent them from using coercive methods to collect repayment.

Why Formal Credit Must Expand

Higher costs of borrowing from informal lenders mean a larger share of the borrower's earnings goes toward repaying loans. This leaves less income for the borrower's own needs. In extreme cases, the repayment amount can exceed the borrower's income, pushing them deeper into debt.

Data shows that 54 per cent of loans taken by poor urban households come from informal sources, while rich households source 83 per cent of their loans from formal channels. This pattern is similar in rural areas. The richer households enjoy cheap credit from banks, whereas the poor are forced to pay much more through informal lenders.

How Do Self-Help Groups (SHGs) Provide Credit to the Poor?

Poor households remain dependent on informal credit for several reasons: banks are not present in all rural areas; bank loans require proper documents and collateral that the poor often lack; and the process of obtaining a bank loan is far more complicated than approaching a local moneylender.

To address this gap, people have developed an innovative approach: Self-Help Groups (SHGs)^?. The idea is to organise the rural poor, particularly women, into small groups of 15–20 members from the same neighbourhood. Members meet regularly and save small amounts — ranging from Rs 25 to Rs 100 or more per person.

How SHGs Work

1. Pooling savings: Members contribute regular savings to a common fund.
2. Internal lending: Members can take small loans from the group's pooled savings at reasonable interest — lower than moneylender rates.
3. Bank eligibility: After one to two years of regular saving, the group becomes eligible for bank loans.
4. Group accountability: The loan is sanctioned in the group's name. All members share responsibility for repayment, ensuring discipline.
5. Self-employment: Loans are used to create income-generating activities — buying seeds, raw materials, sewing machines, handlooms, cattle, or housing materials.

Grameen Bank of Bangladesh

The Grameen Bank of Bangladesh is one of the most successful examples of reaching the poor to meet their credit needs at reasonable rates. Founded in the 1970s as a small project, by 2018 it had over 9 million members across approximately 81,600 villages in Bangladesh. Nearly all borrowers are women from the poorest sections of society, and they have demonstrated that poor women are not only reliable borrowers but can also successfully run small income-generating enterprises.