Discussion Paper No. 152 of 2013 on Determinants of Informal Finance Use in Kenya

Abstract

The financial services sector plays a pivotal role in Kenya’s development by providing better intermediation between savings and investments and mobilization of capital required to implement Vision 2030 projects. However, Kenya’s financial system is dualistic in nature, with a dominant informal finance over formal finance. Informal finance entails financial activities that occur outside the immediate control of government agencies. This study examines the role played by an individual’s attitude towards formal finance and internal business regulation, while controlling individual socio-economic characteristics in determining use of informal finance. It uses data from FinAccess 2009 National Survey. To examine the hypothesized factors, the study used Maximum Likelihood technique to estimate a logit model. The study reveals that negative attitude towards formal finance and internal business regulations play a key role in promoting use of informal finance. Formal institutions in conjunction with the Central Bank of Kenya (CBK) should address the negative attitude by adopting an effective regulatory framework, policies and reforms that would lead to effective transformation of informal to formal finance. These regulations should filter favourably into informal systems, allowing transformation of informal institutions into formal. In addition, formal institutions should address customer needs on a case by case basis, rather than have standardized contracts that may not suit all individuals, hence enhance their flexibility. They should also rein on the escalating fees and other transaction costs that enhance a negative attitude. Similarly, the CBK in conjunction with the Kenya Bankers Association (KBA) and banking institutions should re-evaluate the know your customer (KYC) requirements with a view to weeding out excessive internal regulations that drive away individuals to using informal finance, without compromising on due diligence. Future studies should focus on linkages between formal and informal finance to determine whether they are complementary or substitutes. Further, data collection should be enhanced in order to support evidence-based policy formulation.