Islamic Law and its affects on Risk Mitigation through Informal Credit Rationing in Northern Nigeria

"Credit markets in Northern Nigeria: Credit as Insurance in a Rural Economy" by C. Urdy highlights the overcoming of informational assymetry to mitigate adverse selection, and of enforcement problems to lessen the moral hazard problem, by a humble combination of social sanctions and Islamic Law in the predominantly agricultural Northern Nigeria.

"And if the debtor is in difficulty, then [there should be] postponement to a time of ease" (Koran 2:280)....
Under this law, fixed interest rates and fixed repayment periods for loans are prohibited in a loan contract. Thereby, both the borrower and the lender share positive or negative shocks as they come to the respective household or to the entire village community. This is deviant from credit sanctioning where in the event of a negative shock to the borrower, neither the repayment period nor the interest rate gets changed in most of the cases. On the other hand, in Nigeria, a loan is affected if there is a shock not only to the borrower but also to the lender. So if the borrower gets a positive (negative) income shock or the lender gets a negative (positive) one, the interest rate on the loan would be implicitly higher (lower) than normal.

Two basic identities of formal contracts, collaterals and interlinkage of multi-level contracts are thus absent from this Nigerian setting. Such a phenomenon, however, is badly cushioned with outside help in case the entire village is affected by a negative shock. This is because the loans are mostly made to community members closely knit as family or friends, and social sanctions can be easily used by excluding the defaulter from future opportunities to borrow, or reporting to a village authority such as a religious leader or the village head. Expanding the collateral-less loan environment to a larger area is thus harder because of diminishing confidence in a more estranged community, and also because information flows more easily between borrowers and lenders within an extremely small geographic or social space.

The summary of the paper argues that flexibility of these shock-contingent contracts presents exceptional challenge for formal lenders to enter this market. It fails to point out that the Nigerian example could be followed to set up formal flexible "tiered" interest rate systems by state banks in rural areas so that borrowers and lenders can be more linked in the form of a community than a customer acting as profit making mechanisms for the banks. The paper also does not evaluate the benefits in reducing poverty in rural unbanked locations with potentially negligible costs. Borrower-Lender risk sharing, as spurred in Northern Nigeria because of its religious setting, could be followed as an example in potentially many more Moslem areas which could probably be more willing to accept such a system.

The 1977 Indian Social Banking Experiment: why was the poverty reduction mechanism stopped?

Robin Burgess and Rohini Pande's article, "Can rural banks reduce poverty? Evidence from the Indian Social Bnaking Experiment" examines the effect of forced commercial bank branch expansion into rural areas by the Indian Government from 1977 to 1990.

They however fail to comment on:
A) the reasons why policy of opening 4 bank branches in unbanked locations before opening 1 in already banked locations was discontinued in 1990,
B) the cost of such a program on GDP due to almost 40% default rate in such unbanked rural locations, and
C) the opportunity cost of not being able to open as many urban branches and attaining much higher levels of return on desposits and loans.

Notwithstanding these pitfalls, there are still some important economic lessons to be learnt from the paper. Traditionally it has been argued that bank nationalization and increased formalized credit by the government in rural areas could actually exacerbate poverty, because of elitist groups capturing the subsidy in interest rates to loans in that area and thereby the poor becoming poorer because of lesser and lessser credit available. This paper however shows that opening a bank branch in a rural unbanked location per 100,000 persons reduces rural poverty by 4.74%.

After bank nationalization in 1969, the Indian government, in wanting to improve access of formal credit and saving opportunities to the poor, implemented a policy rule which lead to the opening of bank branches in roughly 30,000 unbanked rural locations from 1969 to 1990. This is commendable especially in India where beuracrcay and corruption drastically marr any infrastrucural or financial develoipment. It was however also necessary because banks before this would always open up more and more branches in urban already banked locations because of high savings and demand of loans at high rates.

The paper thus shows that bank expansion reduced poverty noticeably and exponentially in states with low initial financial development while it did not have much of an effect in urban locations. However, the policy was abandoned in 1990 due to more than 40% default rates and more opening of the economy due to liberalization vanguarded by the present Prime Minister, Dr. Manmohan Singh, as the Finance Minister at that time.

The question though still remains, is a "GDP growth shining" India appreciably better off than a more equitable India with lesser extremes of wealth distribution?