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© 2017 Wolkite University Economics Department WKU/ECON/006/2018

WKU ECON Working Paper

Economics Department

“Determinates of house hold to participate in informal financial institution and the role of
informal financial institution”
Prepared by: Melese Getu
Authorized for distribution by: Biruk Birhanu
October 20018

Abstract
The sights articulated in this Working Paper are those of the author(s) and do not necessarily
represent those of the WKU or WKU policy. Working Papers describe either research in
progress by the author (s), research review, or article review and are published to elicit
comments and to further debate.
The determinants of household to participate in informal finance institution and the role of informal
financial institution on the lively hood household were examined in this study by considering how IFFI
improved the livelihood of households and reducing poverty.
There were IFI, which play a great role in improving the livelihoods of households. IFFI are an
Indigenous institution such as Mahiber, Iddir, Iqqub, and Elders’ councils which are flexible, dynamic
and complex organizations providing socio religious, economic and quasi legal services” in rural area.
In conducting the research, the researcher was used both primary and secondary data. The study was
presented the result by descriptive statistics methods of data analysis and by econometric model of binary
logistic model. Quantitative data will be analyzed using descriptive statistics.
Stand from the determinant factor the researcher recommended that the government and non-government
organization should give awareness about importance of those IFFI, give legal protection and principle
for their formality, rearrange the organizational structure of the IFFI.

Key words: formal and informal financial institution, determinant factors, poverty, household

Authors’ E-Mail Addresses: melese.getu@wku.edu.et

Assistance lecturer at Wolkite University, Economics department

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Table of Contents
1. INTRODUCTION ...................................................................................................................... 1
2 REVIEW LITRATURE ............................................................................................................... 1
2.1 Theoretical literature review ................................................................................................. 1
2.1.1 Informal Finance Institution .......................................................................................... 1
2.1.3 The Role of Informal Financial Institution ..................................................................... 4
2.1.4 The livelihood framework .............................................................................................. 5
2.1.5 Livelihood security ......................................................................................................... 6
2.2 Empirical literature review .................................................................................................... 6
3. Conclusion .................................................................................................................................. 7
4. Outlook from Conclusion ........................................................................................................... 8
REFERENCES ............................................................................................................................. 10

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1. INTRODUCTION
The informal finance institution had played major role in strengthen the rural economy, because
it claims itself to be the main sources of finance to its rural clients and it enable them purchase of
farm inputs such as seed herbicides fertilizers…… etc. and purchase of consumption good such
as food, clothes, covering children’s educational expenses and also starting or financing new
business (Teresa, 2006).
The informal financial initiation in Ethiopia comprises mainly of Iqqub (rotating and saving
scheme), Iddir (traditional insurance institution scheme), and money lender “arataabedari’ etc.
Relatives and friends are the other major traditional sources of finance as identified and
described by many authors, (Dejene, 2003). It is estimated that 78% of total agricultural credit in

Ethiopia stems from informal finance institution (Dejene, 2003). According to the same sources
of the household’s survey 66% secured financial services from relatives and friends, 15% from
money lenders and the rest of 19% from other sources indicated that only 7% possessed bank
account (Dejene, 2003). It is well known that the formal financial institution is mostly urban
centered and as well as to procedural particularly for the poor and un educated majority of the
country’s population, therefore, the bulk of the rural households may be reluctant to use the
formal financial institution rather they prefer rely on informal finance institution, that is well
adopted or acceptable to their cultures and customs (Solomon, 2002).

2 REVIEW LITRATURE
2.1 Theoretical literature review
2.1.1 Informal Finance Institution

2.1.1.1 Iqqub
Iqqub is one of the most common traditional practices of saving cash for the future investment in
the most parts of Ethiopia. It is a form of social organization in which members come together
for the purpose of saving in case or in kind self-help associations. Cash is contributed by
members very fixed day in a week or in a month in successive rounds and given to members
after drawing a lottery. It is not open to all members; it is open only to those who are able to
regularly contribute the agreed sum of money (Aspen 2005).

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Iqqub is rotating type of fund raising and one does not entertain any fear of losing this money,
because of social ties and collateral security association with Iqqub. Functioning, when a
member gets the money, other members who has not collect his/her share, will be his/her
guarantor. The guarantor for his liable to pay the members depts. this builds up the confidence of
the members (Kejela et al, 2006).

2.1.1.2. Iddir – the Social Insurance


Iddir is an informal finance institution or association established by the community members to
provide social security during certain specified types of crisis occurred to its members (Kejela et
al, 2006). In this sense, Iddir is a sort of insurance program run by community or a group of
people in terms of emergence like death of family members.
Now a day’s Iddir provides a wider range of services including financial and material assistance
and consolation to a member in the events of difficulties, as well as entertainments (Salole,
2006). Some Iddir provide assistance in the events of shocking apart from death, such as fire,
illness, loss of oxen or other livestock and harvest, destruction of house, weeding and any other
events. During such circumstances, Iddir will either given cash transfer or give loan (Hoddinott
et al, 2005).

2.1.1.3. Money lenders


In most cases, money lenders are part – time lenders who supplement their income through
money lending; usually they have long standing relationship with their borrowers and the well
informed about the borrowers. Mostly the moneylenders are farmers, shopkeepers, salaried
employees and business persons. The financial operations of moneylenders are simple cost
effective as compared to those of banking systems (Kejela et al, 2006).

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2.1.1.4 Credit from Friends and relatives
In Ethiopia where there is long tradition of mutual assistance and reciprocity, individuals who
need funds call friends and relatives for help. Acceptance of such help obligates the borrowers to
reciprocate by providing non- financial services or by supporting funds in turn when the lender
need to borrow. Lending between friends and relatives often carries low interest or no interest
charge and oral agreement, confidence, trust and mutuality are frequently all that is needed as
collateral or security (G/Yohannes, 2000).
This type of loan source is well known in most part of the country and accounts for a large share
as compared with other sources of loan. A needy person can get interest free loan from relatives
and close friends (G/Yohannes, 2000).

2.1.2 Characteristics of informal finance institution


2.1.2.1 Informality

The informal finance institution has written rule as formal finance institution. It derives its rule
and regulation from society’s cultures and customs. This indicated the cost per transaction is less
and it involves less bureaucratic procedures, and delays elaborate per workers, (Kejela et al,
2006).

2.1.2.2 Collateral

Depending on the relation between the borrower and lender, usually informal finance institution
demand assets such as houses, shops, live stocks, lands or personal guarantors. If a good
relationship exists between the group lenders, then loan transaction may be executed mutual trust
only. In most of the case, informal finance institution is required to bring a guarantor. The
guarantor is expected to be dependable and of good reputation and relatively wealthy, (Kejela et
al, 2006)

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2.1.2.3 Flexibility
In general, borrowers believe that the informal finance institution is more flexible than the
formal system. The IFI is highly flexible in terms of interest charges and rescheduling of
repayment period. Based on the request of the borrowers the loan repayment period can be
flexible and rescheduled up on the request of the borrowers and consent of the lenders. It can be
extended for another one or two years. A new agreement is made for the rescheduling of debt
repayment (Kejela et al, 2006).

2.1.2.4 Enforcement Mechanism of Loan Repayment


Enforcement may be through the elders and the courts of the laws. As indicated by G/Yohannes
(2000) the informal lenders have easy access to information about their borrowers, with whom
they have socially relationships. This permits credit contracts to play a major role in enforcing re
payment.

2.1.2.5 Interest Rates


In rural areas both interest free loans from friends and relatives and interest bearing ones
operates side by side. According to a study by lexander (1998) interest rate varied with in a
village depending on the types of relationship between the contracting partners. Those who are
closely related to the moneylender or loyal to him pay low interest rate (or even no interest).
There could be also inter – regional and temporal variation in magnitudes of interest rate.

2.1.3 The Role of Informal Financial Institution


Informal finance institution plays a great role in rural Ethiopian economy. In general term the
role of informal finance institution has for rural society is in poverty reduction. Specifically, it
plays role in household’s capital accumulation, in encouraging investments and saving, to
overcome case of emergence such as death and illness and many other roles (Dejene, 2003).

2.1.3.1 Household capital accumulation


(Assefa,2003). Informal finance institution plays a great role in house hold capital accumulation
for rural people. Rural people use IFI as bank, it is called rural bank. Money saved in form of
informal financial institution increase from time to time and then brings the capital accumulation.

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2.1.3. 2 Informal financial institution and poverty reduction
Informal financial institutions are institutions that embraced all financial transactions that take
place beyond the functional scope of various countries banking and other formal financial sector
regulations (Argeetey 2002), chipeta and mkandawaivre (2002) saw them as financial institution
are not directly an able to control by key monetary and financial policy instruments. These
institutions are usually created by organization and individuals and with no legal status.

2.1.3.3 Poverty reduction


Poverty is lack of basic human need such as lack of food, clean water, lack of education and
shelter. This is common feature for rural people those who are far from formal financial service
such as bank and other credit institution. So for rural people, IFI provides financial services to
overcome the problem of poverty (Kejela et al, 2006).

2.1.4 The livelihood framework


The livelihoods framework is a way of looking at the complexity of people’s livelihoods,
especially the livelihoods of the poor, whether they are rural or urban. It seeks to understand the
various dimensions of a person’s livelihood; the strategies and objectives pursued and associated
opportunities and constraints.
The livelihood strategies and activities of poor people are often complex and diverse. For rural
people agriculture and other natural resource based activities’ may play an important role, but
rural households also diversify in to other activities some of which are linked to agriculture and
the natural resource sector other which are not. Strategies may include subsistence production or
production for the market, participation in labor markets or laboring in the home, poor urban
people also depends up on multiple diverse livelihood activities involving different employment
(Laboring) and self-employment activates (WWW. Cefims, acuk page 13 htm).

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2.1.5 Livelihood security
In relation to livelihood security take a particular note of destination between income level,
income stability (regularity) and degrees of risk. Income level is obviously important to people,
but to poor people income stability and risk avoidance may be as important, if not more so. Also
bear in mind that income in the livelihood security box does not just refers to monetary income
but also to incomes in kind, such as the food produced by small holder farmers for home
consumption.
Seasonality refers to the fact that many rural livelihood strategies (especially in agriculture)
result in seasonal fluctuations in income. This affects livelihood security, and people usually try
to reduce seasonal income fluctuations or their vulnerability to them.

2.2 Empirical literature review

The inability of the formal financial sector to provide adequate financial services to small
farmers and the poor in general continued even after the reform (Assefa 2003). A study by the
National Bank of Ethiopia (2006) concluded that “CBE and DBE have only catered for
insignificant demand for credit of small farmers. The bulk of financial services provided to small
and micro-enterprises in rural and urban areas, therefore, mostly originated from the informal
sector such as Iqqub, moneylenders and friends” (NBE, 2006)

On the other hand, as Dejene (2003) stated the non-formal sources in Ethiopia include relatives
and friends, moneylenders, neighbors, Iddir, Iqqub and Mahiber. The major sources of loans
include friends and relatives (66 percent), moneylenders (14 percent), and Iddir (7 percent). In
other words, the bulk of the rural credit comes from informal sources. Every year, the informal
sector mobilizes resources equivalent to about 10 percent of deposits mobilized by all banks in
Ethiopia. Rural Iddir mobilized through informal loans alone an amount 3.5 times the total
capital of all micro finance institutions in Ethiopia.
As Summery; The researcher is used both theoretical and empirical literatures review from
different sources like: CNS 2007, wolkite branch of agricultural sector, CBE, DBE, IIRR and the
researcher also used the other researcher recommendation as the empirical review that deals
about the household participations of informal financial institution:

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The bulk of financial services provided to small and micro-enterprises in rural and urban areas,
therefore, mostly originated from the informal sector such as Iqqub, moneylenders and friends.
The above sourcesreview that the most widely used financial institutions in rural areas were
informal, which provided very small loan size, for short period and especially for daily
consumption. however, it is argued that informal sources, do not generate enough and
affordablefinance for business to stimulate economic development so need further research to
address the problem.

3. Conclusion

Like most developing countries informal financial institutions have been wide spread in Ethiopia
particularly in rural areas, because of lack of sufficient banking and financial institutions in
country besides, the elaborate paper work, high transaction cost delay and collateral
requirements. The majority of the poor and uneducated rural population, farm households has
been relying almost exclusively on informal finance institutions prevailed in their surroundings.
Some of the most common informal finance includes mainly, Iqqub, Iddir and money lender are
adapted in wolkite District.
The households that participate in the IFI obtain the following benefits than non-participants in
the study area; Obtain a wider range of services including financial and material assistance in the
events funeral ceremony, harvest, and difficulties such as fire, illness and destruction of house. A
cash transfers or loans in case where the members have lost oxen or other livestock, cost their
house or are paying for weeding or some other events. Economic benefit could be in the form of
contribution during the death of family members as well as having access to getting credit.
Obtain credit services in an indirect way. Lend money or take loan to purchase farm inputs like
seeds, fertilizers, herbicides, pesticides and consumption goods on the purpose of food, drink, or
other goods for households or to pay for travel, health, education (from interview).

Informal finance takes shorter time than formal finance institutions to process loan. Loan
acquisition from informal finance institutions is relatively quick, easy and flexible with less
transaction cost for the intermediate of borrowers.

Generally, the effectiveness and development of informal financial institution depends on the
participation of the household in those institutions. Informal financial institution was found out

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with logit model results that the most considerable factors that affect participation of the
household in the IFI in the study area were educational level of household, religion that the
household follows, marital status the household and occupation of the house hold. The study has
revealed that a relatively large proportion of the interviewed had a low level of education, of
which the majority had not finished Primary school. evident that many interviewees lacked
adequate information concerning the organizational structure of IFI as well as their obligations.
Yet at the same time, many low-educated clients who were not participating in IFI had not aware
of how to economize and accumulate funds through their participation in IFI.

The study has revealed that a relatively large portion of the respondents had engaged on privet
work than on government those few respondents in the area were not participate in IFI due to
some reason that they were not participate IFI especially in Iqqub is shortage of income and the
lack of interest rate in those IFI.
The major constraints that determine the participation of the household in informal financial
institution were identified as follows: no interest rates, too small loan sizes, Lack of training, no
government assistance, lack of efficient legal protection, backward by-laws and book-keeping
system, backward thinking about the informal financial institution and lack of awareness about
the economic contribution of IFI (from interview).
Lastly, from the conclusion the researcher went to say for anybody who went to do different
activity by using a research paper they should be tack care off. Because, it may have some
limitation due to different constraint and lack of experience in research so it may need further
research by adding more and more constraints variable to find the other determinant. But, the
paper used as guide line for either researcher or policy maker.

4. Outlook from Conclusion


All thus need to be adequately addressed in order to enhance the participation of household IFI and to
improve their livelihood in the study area. Based on the above mentioned points, the following
recommendations could be given to promote the participation of the household in the informal financial
institutions in the study area. For the development of informal financial institutions, the active
participation of the household is base. So, to increase the participation of the household and their lively
hood, the major determinant factor of the household to participate in informal financial institution should
be avoided.

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The stake holder should be creating awareness and training about how to economize and
accumulate fund through participating in informal financial institution.
Provide information concerning the organizational structure as well as the obligation of informal
financial institutions for those who haven’t awareness about obligation of those institutions.
Organizing and participating the rural people to up grading their IFI in their area.
Establishing and strengthen the potential linkages between informal and formal institution, and
supported by-laws and book-keeping systems of these institutions should be updated and
systematized.
Policy makers should create an enabling environment rather than stifling (cool) the energies and
creativities of people participating in these indigenous and culturally appropriate financial
institutions, and appropriate policies need to transform existing traditional informal financial
institutions into modern one,
The informal sectors in the study area were evolved, through trial and error without government
assistance, so government support and assistance should be given to the informal financial
institutions.
Government should give legal protection for IFI from embezzlement and mismanagement by
swindlers and give reward especially for a person who participates actively in such informal
financial institution to increase the participant.
In the most part of rural area, the household’s lively hood is endangering. So, at least they should
be participating in their indigenous institutions to improve their lively hood if they cannot
participate in formal financial institution.
The privet, government or non-government organization who participates in formal financial
institution should give reward for rural household who is in better living standard by
participating in IFFI.
Stack holder should be aware the households they can be save, invest and become rich by using
IFFI by avoiding backward thinking about IFFI and Being start book keeping system by
cooperating with formal financial institution.
.

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REFERENCES
Assefa A, (2003). Rural finance in Ethiopia. Assessment of the financial products of micro
finance institutions. AEMFI, occasional paper No 12, Addis Abeba.

Dejene, A, (2003) Informal credit and informal market in developing countries. A preliminary
survey of literature. Addis Ababa Ethiopia.

Kejela S, J. (2006). Group based funerass insurance in Ethiopia and Tanzania. Working paper
227. Oxford center for the study of Africaneconomies, University of oxford

Selmon, (2003). Types of IF institution in Ethiopia. show that similar types of ROSCAS
institution are present in Ethiopia serving the society with both credit and saving function.

Teresa, (2006). Formal financial institutions. have not developed to expectation and have hardly
reached the rural population.

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