MICROFINANCE PAPER WRAP-UP: “Informal Finance in Sierra Leone: Why and How it Fits into the Financial System,” by Ilara Mahdi

This is a summary of a paper written by IIara Mahdi, 2018, 32 pages, available at http://www.findevgateway.org/sites/default/files/publication_files/informal_finance_in_sierra_leone-working_paper_i.m_final_160718_1.pdf

This paper outlines possible reasons for the continued prominence of the informal financial sector in Sierra Leone despite the innovations and growth that have occurred in the formal sector since the 1990s. Informal finance channels such as unregulated – generally nonprofit – microfinance institutions (MFIs), mobile money platforms, and savings and credit clubs continue to be popular in many parts of sub-Saharan Africa including Sierra Leone.

The author outlines the history of Sierra Leone from the 1800s – before its independence from Great Britain – and continuing into the post-war period of the past few years. With the recent liberalization of the economy, the commercial banking sector has grown significantly. The number of commercial banks jumped from 4 to 13 between 2000 and 2016. Total banking assets grew from 20 percent of GDP in 2007 to 26 percent of GDP in 2016.

Dr Mahdi introduces four theories for the continued strength of the informal financial sector in the face of these trends. According to the “financial repression” theory, the formal financial sector excludes poor people due to regulations such as interest rate ceilings that are tailored to larger companies and people with higher incomes. According to the “institutionalist” school of thought, financial institutions operating in Africa are poorly equipped to manage financial risks and thus seek to serve larger clients because they perceive these clients to pose lower risk levels. The “imperfect information” theory predicts that channels specializing in different types of transactions will emerge and persist when there are significant limitations on the availability of information and the enforcement of contracts. Lastly, the “structuralist” school of thought posits that the social mission of the informal financial sector drives it to persevere despite the expansion of the formal financial sector.

Even with the recent growth in traditional banks, only 12.6 percent of people in Sierra Leone are served by the formal financial sector. The country’s government continues to focus on “community banks” and MFIs to expand financial inclusion. As of 2016, community banks in the country deliver savings and other services to approximately 16,000 people in rural parts of the country. Financial service associations (FSAs) recently have been established via commercial banks to complement community banks. FSAs are membership-based institutions that pool funds to enable community lending. Despite the government’s promotion of MFIs, there are only 10 regulated MFIs in the country, serving 78,000 people. Only two of these 10 MFIs accept deposits.

In conclusion, the author argues that informal finance will continue to exist alongside the formal financial sector due to interdependence of the two. The formal system does not currently meet the needs of over 80 percent of the population. MFIs face challenges such as lack of transportation infrastructure, restrictive lending regulation policies and limited access to wholesale funding. Other reasons for the likely continued coexistence of the formal and informal sectors include “historical and social factors,” such as colonization by the British and the dollarization of the economy after the collapse of the formal financial sector in the 1990s.

By Michelle Fleming, Research Associate

Sources and Additional Resources

“Informal Finance in Sierra Leone: Why and How it Fits into the Financial System,” by Ilara Mahdi
http://www.findevgateway.org/sites/default/files/publication_files/informal_finance_in_sierra_leone-working_paper_i.m_final_160718_1.pdf

Do you know that MicroCapital publishes the MicroCapital Monitor newspaper each month? Find out more at https://www.microcapital.org/products-page/.