Skip to main content

Dual Financial Systems and Inequalities in Economic Development

Journal of Economic Growth volume 8, pages 223–257 (2003)Cite this article

Abstract

This paper analyzes the emergence and the evolution of a modern banking system, in a developing economy where banks coexist with informal credit institutions. Banks have a superior ability in mobilizing savings while informal lenders enjoy a superior information on borrowers. More specifically, banks cannot observe perfectly the behavior of borrowers; therefore the latter need to provide collateral assets in order to obtain bank loans. Physical collateral is not needed to borrow in the informal credit market: informal lenders can rely on social networks to obtain information on borrowers' behavior and invoke social sanctions to enforce repayment. The sustained growth path is associated with the successful development of the banking system that gathers savings on a large scale. However, informal lenders and other traditional credit institutions are necessary in the first stage of development when collateral is scarce. In this economy, the development of modern financial intermediaries is closely associated with the accumulation of collateral assets by entrepreneurs. This implies that the initial level of development as well as the initial distribution of wealth will determine the joint evolution of the real side of the economy and the financial system. Under certain conditions, two long-run steady-state equilibria exist: in the first one the economy stops growing and the banking system never successfully develops; in the second one the economy reaches a sustained growth rate and the informal sector asymptotically vanishes. The impact of the following policies is discussed: financial repression, micro-credit institutions and redistribution of assets.

This is a preview of subscription content, access via your institution.

Access options

Buy single article

Instant access to the full article PDF.

USD 39.95

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

References

  • Acemoglu, D., and F. Zilibotti. (1996). “Agency Costs in the Process of Development,” CEPR DP no. 421.

  • Acemoglu, D., and F. Zilibotti. (1999). “Information Accumulation in Development,” Journal of Economic Growth 4(1), 5-39.

    Google Scholar 

  • Aghion, P., and P. Bolton. (1997). “A Trickle-Down Theory of Growth and Development with Debt-Overhang,” Review of Economic Studies LXIV, 151-172.

    Google Scholar 

  • Aleem, I. (1990). “Imperfect Information, Screening, and the Costs of Informal Lending: A Study of a Rural Credit Market in Pakistan,” The World Bank Economic Review IV, 329-350.

    Google Scholar 

  • Armendariz de Aghion, B. (1999). “Development Banking,” Journal of Development Economics 83-100.

  • Armendariz de Aghion, B. (1999). “On the Design of a Credit Agreement with Peer Monitoring,” Journal of Development Economics 60, 79-104.

    Google Scholar 

  • Armendariz de Aghion, B., and C. Collier. (2000). “Peer Group Formation in an Adverse Selection Model,” The Economic Journal 465, 632-643.

    Google Scholar 

  • Banerjee. A., T. Besley, and T. Guinnane. (1994). “Thy Neighbor's Keeper: the Design of a Credit Cooperative with Theory and a Test,” Quarterly Journal of Economics 109(2), 491-515.

    Google Scholar 

  • Banerjee, A., and E. Duflo. (2002). “Do Firms Want to Borrow More? Testing Credit Constraints Using a Directed Lending Program.” Mimeo: MIT.

  • Banerjee, A., and A. Newman. (1993). “Occupational Choice and the Process of Development,” Journal of Political Economy CI, 274-298.

    Google Scholar 

  • Banerjee, A., and A. Newman. (1998). “Information, the Dual Economy, and Development,” Review of Economic Studies LXV, 631-653.

    Google Scholar 

  • Bencinvenga, V. R., and B. D. Smith. (1991). “Financial Intermediation and Endogenous Growth,” Review of Economic Studies LVIII, 195-209.

    Google Scholar 

  • Bencinvenga, V. R., and B. D. Smith. (1993). “Some Consequences of Credit Rationing in an Endogenous Growth Model,” Journal of Economic Dynamics and Control XVII, 97-122.

    Google Scholar 

  • Berthelemy, J. C., and A. Varoudakis. (1994). “Convergence Clubs and Growth: The Role of Financial Development and Education,” Oxford Economic Review XLVIII, 300-328.

    Google Scholar 

  • Besley, T. (1995). “Nonmarket Institutions for Credit and Risk Sharing in Low-Income Countries,” Journal of Economic Perspectives 9(3), 115-127.

    Google Scholar 

  • Besley, T., and S. Coate. (1995). “Group Lending, Repayment Incentives and Social Collateral,” Journal of Development Economics 46(1), 1-18.

    Google Scholar 

  • Besley, T., and A. Levenson. (1996). “The Anatomy of an Informal Financial Market: Rosca Participation in Taiwan,” Journal of Development Economics 51.

  • Bond, P., and A. Rai. (2002). “Collateral Substitutes in Microfinance.” Mimeo: Northwestern University.

  • Bose, P. (1998). “Formal-Informal Sector Interaction in Rural Credit Markets,” Journal of Development Economics 56, 265-280.

    Google Scholar 

  • Braudel, F., and E. Labrousse. (1976). A Social and Economic History of France, Part III. Paris: Presses Universitaires de France.

    Google Scholar 

  • Cameron, R., et al. (1967). Banking in the Early Stages of Industrialization — A Study in Comparative Economic History. Oxford: Oxford University Press.

    Google Scholar 

  • Cole, D., and Y. C. Park. (1983). Financial Development in Korea 1945–1978. Cambridge, MA: Harvard University, Council on East Asian Studies, Harvard University Press.

    Google Scholar 

  • Diamond, D. (1984). “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies LI, 393-414.

    Google Scholar 

  • Freixas, X., and J. C. Rochet. (1997). Microeconomics of Banking. Cambridge, MA: The MIT Press.

    Google Scholar 

  • Fry, M. J. (1995). Money, Interest and Banking in Economic Development, 2nd edn. London: The Johns Hopkins Studies in Development.

    Google Scholar 

  • Galor, O., and J. Zeira. (1993). “Income Distribution and Macroeconomics,” Review of Economic Studies LX, 35-52.

    Google Scholar 

  • Ghatak, M. (2000). “Joint Liability Credit Contracts and the Peer Selection Effect,” Economic Journal 110(465) (July), 601-631.

    Google Scholar 

  • Ghatak, M., and T. Guinnane. (1999). “The Economics of Lending with Joint Liability: Theory and Practice,” Journal of Development Economics 60, 195-228.

    Google Scholar 

  • Goldsmith, R. W. (1969). Financial Structure and Development. New Haven, CT: Yale University Press.

    Google Scholar 

  • Greenwood, J., and B. Jovanovic. (1990). “Financial Development, Growth, and the Distribution of Income,” Journal of Political Economy XCVIII, 1076-1107.

    Google Scholar 

  • Hoff, K., and J. E. Stiglitz. (1990). “Introduction: Imperfect Information and Rural Credit Markets-Puzzles and Policy Perspectives,” The World Bank Economic Review IV, 235-250.

    Google Scholar 

  • Hoff, K., and J. E. Stiglitz. (1997). “Moneylenders and Bankers: Price-Increasing Subsidies in a Monopolistically Competitive Market,” Journal of Development Economics 52, 429-462.

    Google Scholar 

  • Holmström, B., and J. Tirole. (1997). “Financial Intermediation, Loanable Funds and the Real Sector,” The Quarterly Journal of Economics 112(3), 663-691.

    Google Scholar 

  • Hopenhayn, H., and E. Prescott. (1992). “Stochastic Monotonicity and Stationary Distribution for Dynanic Economies,” Econometrica LX, 1387-1406.

    Google Scholar 

  • Jain, S. (1999). “Symbiosis vs. Crowding-out: the Interaction of Formal and Informal Credit Markets in Developing Countries,” Journal of Development Economics 59, 419-444.

    Google Scholar 

  • Kan, K. (2000). “Informal Capital Sources and Household Investment: Evidence from Taiwan,” Journal of Development Economics 62, 209-232.

    Google Scholar 

  • Kindlerberger, C. (1976). A Financial History of Western Europe. London: G. Allen and Unwin Publishers.

    Google Scholar 

  • King, R. G., and R. Levine. (1993a). “Finance and Growth: Schumpeter Might be Right,” The Quarterly Journal of Economics CVIII, 713-737.

    Google Scholar 

  • King, R. G., and R. Levine. (1993b). “Finance, Entrepreneurship, and Growth: Theory and Evidence,” Journal of Monetary Economics XXXII, 513-542.

    Google Scholar 

  • Laffont, J. J, and T. T. N'Guessan. (1999). “Group Lending with Adverse Selection,” European Economic Review.

  • Levine, R. (1997). “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature XXXV, 688-726.

    Google Scholar 

  • Lloyd-Ellis, H., and D. Bernhardt. (2000). “Enterprise, Inequality and Economic Development,” Review of Economic Studies 67, 147-168.

    Google Scholar 

  • McLeod, R. H. (1991). “Informal and Formal Sector Finance in Indonesia: The Financial Evolution of Small Businesses,” Savings and Development XV, 187-209.

    Google Scholar 

  • MacKinnon, R. (1973). Money and Capital in Economic Development. Washington. D.C.: Brookings Institution.

    Google Scholar 

  • McMillan, J., and C. Woodruff. (1999). “Interfirm Relationships and Informal Credit in Vietnam,” The Quarterly Journal of Economics November, 1285-1320.

  • Montiel, P., P.-R. Agenor, and N. Ul Haque. (1993). Informal Financial Markets in Developing Countries. Cambridge USA: Blackwell Publishers.

    Google Scholar 

  • Morduch, J. (1999). “The Microfinance Promise,” Journal of Economic Literature 37(4), 1569-1614.

    Google Scholar 

  • Nabi, I. (1989). “Investment in Segmented Capital Markets,” The Quarterly Journal of Economics 104(3) (Aug.), 453-462.

    Google Scholar 

  • Pagano, M. (1993). “Financial Markets and Growth: an Overview,” European Economic Review XXXVII, 613-622.

    Google Scholar 

  • Paulson, A., and R. Townsend. (2001). “Entrepreneurship and Financial Constraints in Thailand.” Mimeo: University of Chicago.

  • Piketty, T. (1997). “The Dynamics of the Wealth Distribution and the Interest Rate with Credit Rationing,” Review of Economic Studies LXIV, 173-189.

    Google Scholar 

  • Roubini, N., and X. Sala-i-Martin. (1992). “Financial Repression and Economic Growth,” Journal of Development Economics XXXIX, 5-30.

    Google Scholar 

  • Saint Paul, G. (1992). “Technological Choice, Financial Markets and Economic Development,” European Economic Review XXXVI, 763-781.

    Google Scholar 

  • Shaw, E. S. (1973). Financial Deepening in Economic Development. New York: Oxford University Press.

    Google Scholar 

  • Siamwalla, A., et al. (1990). “The Thai Rural Credit System: Public Subsidies, Private Information, and Segmented Markets,” The World Bank Economic Review IV, 271-296.

    Google Scholar 

  • Stiglitz, J. E. (1990). “Peer Monitoring and Credit Markets,” The World Bank Economic Review IV, 351-366.

    Google Scholar 

  • Stiglitz, J. E., and A. Weiss. (1981). “Credit Rationing with imperfect information,” The American Economic Review LXXI, 393-410.

    Google Scholar 

  • Sussman, O., and J. Zeira. (1995). “Banking and Development,” CEPR D.P. no 1127.

  • Townsend, R. M. (1979). “Optimal Contracts and Competitive Markets with Costly State Verification,” Journal of Economics Theory 21(2), 265-293.

    Google Scholar 

  • Townsend, R. M. (1994). “Risk and Insurance in Village India,” Econometrica LXII, 539-592.

    Google Scholar 

  • Townsend, R. M. (1995). “Financial Systems in Northern Thai Villages,” The Quarterly Journal of Economics 1011-1046.

  • Udry, C. (1990). “Credit Markets in Northern Nigeria: Credit as Insurance in a Rural Economy,” World Bank Economic Review September, 251-259.

Download references

Author information

Authors and Affiliations

  1. Research Department, International Monetary Fund, 700 19th Street N.W., Washington DC, 20431, USA

    Thierry Tressel

Authors
  1. Thierry Tressel
    View author publications

    You can also search for this author in PubMed Google Scholar

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Tressel, T. Dual Financial Systems and Inequalities in Economic Development. Journal of Economic Growth 8, 223–257 (2003). https://doi.org/10.1023/A:1024464506029

Download citation

  • Issue Date:

  • DOI: https://doi.org/10.1023/A:1024464506029

  • economic development
  • financial deepening
  • financial repression
  • informal credit