Formal source of credit includes all the sources for raising the credit from the institutions which are functioning under the guidelines of RBI or which work with specific rules and regulations. They are more reliable than informal sources. Banks and cooperatives are the main formal sources of credit.
The credit from the informal source is getting loans from institutions that do not come under the purview of any legal entity. Credit from these sources moneylenders, friends, relatives, traders and employer can be included under the informal sources of credit. The rural poor mainly depend on informal sources of credit because:
- Most of the formal sources of credit will be cheap compared to informal sources. Even though banks advance the loans with cheaper interest rate poor households are not able to avail that loan due to terms of credit and formalities.
- The requirement of collateral for taking loans from institutional sources makes it impossible for the poor to take loans from banks and other institutions. Thus they have to rely on other informal sources.
- Rural poor are not aware of the banking system because of the lack of education and awareness. Therefore they are forced to acquire a loan from the informal sources. Most of the people in rural areas don't have access to native bankers and other financial institution, this increases the share of informal sources of credit among the poor households.
Because of these reasons, the informal sources will be the most preferred by the poor households. The major steps that can be taken to encourage them to take loans from the formal sources are:
- Bring awareness: The rural poor must be given relevant awareness that formal source of credit can be obtained with a much lower interest rate than the informal sources. They must also be aware of the debt trap they are facing and the exploitation done by the informal source lenders.
- Cooperatives: Establishing the cooperative banks in all the rural areas will help the rural poor to reduce their dependence on the informal source lenders. The lenders must have proper knowledge of the area and people they are dealing with.
- SHGs: Promoting more number of Self Help Groups (SHGs) which will promote the rural poor to save the money by depositing it weekly and withdrawing it when required. Members of the SHGs should also take an initiative to bring awareness about the formal source of credit throughout the village.
- Legal steps: Laws and regulations must be enacted to control the informal sources of credit, especially money lenders. Both the lenders and borrowers must face legal implications if transactions are conducted through informal sources.
- Terms of credit: All the factors including interest rate, collateral, documents required and mode of repayment altogether comprise terms of credit. The terms of credit for advancing a loan from the banks should not be rigid. The documents required must be such that the rural poor should be able to afford it.