Knowledge Bank

A paradoxical situation has emerged in rural financial markets in low income countries in recent years. Most programs implemented to extend the frontier of formal finance into rural areas have failed at the same time that informal finance has thrived. This paper explains this paradox in terms of asymmetric information and transaction costs. A number of new innovations have been developed in microfinance which involves lenders, frequently NGOs, making small short-term loans to poor urban borrowers. The nature of these innovations is outlined. Although the microfinance results suggest possibilities for resolving the problems afflicting rural and agricultural finance, there are concerns about how far these new innovations can be extended beyond urban areas. Several of these concerns are discussed.