In India, all the ways in which people get and give money is known as formal or informal financial system. These systems assist people in saving, borrowing, and investing. Formal system: this consists of banks and regulated institutions. The informal system consists of friends and moneylenders and lenders in the area. India’s economy is supported by the formal and informal financial system. Formal systems follow rules. Informal systems operate in the absence of legal rules. And together, they define how money is spent and saved in urban and rural areas.
According to the formal and informal financial system definition provided by the RBI, the financial systems in a country can be divided into two broad categories. In order to understand how people manage money in India, one must understand the nature of the formal and informal financial system. The formal system relies on banks and legal finance companies. The informal system consists of unregistered lenders and personal borrowing. The two institutions however play significant roles in everyday life, especially rural and semi-urban India.
Formal Financial System
Regulated financial institutions are part of the formal financial system. They are governed by the rules of the Reserve Bank of India (RBI). Consumer Finance: It covers vehicles, education, housing, and other consumer-centric loans like retail loans, with commercial banks, cooperative banks, NBFCs, and MFIs. These are the formal blood vessels of the credit system. They make loans, accept deposits and provide insurance and investment services.
Types of formal System
- Commercial Banks (SBI, HDFC, etc.)
- Cooperative Banks
- Regional Rural Banks (RRBs)
- NBFC (Non-Banking Financial Company)
- Microfinance Institutions
These institutions engender trust. They give low-interest loans. That’s long-term financial assistance. This special system is used by students, small business owners, and salaried people. It’s really effective in cities and urban areas.
In India, the banking system operates under RBI regulations. It is an aid to keep savings secure. It makes money move faster. The system enables digital payments, online banking, and financial inclusion.
Informal Financial System
Lenders within the informal financial system do not adhere to official regulations. It includes informal credit sources such as moneylenders, friends, relatives, and local traders. These men issue loans without paperwork. They charge high interest. But they act quickly and are easily accessible.
Informal Lending Practices
- Loans without any security
- No paperwork, No hard deadline to pay it back
- Strong interest from the verbal in hand
It is useful where the banks are not in the vicinity. Most people in villages, small towns. An unregulated financial sector is dangerous. Any formal reach as you continue to see it, many of poor families depend on it. In most of India the informal credit still dominates the rural credit system.
The informal system is useful in emergencies. But it is also a path to debt traps. Individuals borrow and default on loans. It leads to stress and losing property. There’s literally no legal protection for the system.
Classification of Formal Financial Structure
All regulated financial institutions are considered formal financial institutions. These are subject to government and RBI regulations. They keep legal records, confirm identity and protect consumer safety. These are the formal credit system in India.
Commercial Banks
These are the most important part of the banking system in India, known as the commercial banks. For example: SBI, HDFC, ICICI, Bank of Baroda. These include savings accounts, loans, fixed deposits, etc. These banks are used for personal, business, or government finance.
Cooperative Banks
These are member-owned banks. They are prevalent or more prominent in rural and semi-urban areas. They assist farmers, workers and small traders. They make simple loans and take deposits.
Regional Rural Banks (RRBs)
RRBs bonds the rural credit system. They offer low-interest loans to farmers, artisans and small business owners. They are backed by larger commercial banks, but operate in the villages.
Non-Banking Financial Company (NBFCs)
Non-banking financial companies (NBFCs) are not grant full banking licenses; NBFCs provide loans and investment services. Some of them include Bajaj Finance, Mahindra Finance etc. They offer lending, insurance, and leasing services
MFIs (Microfinance Institutions)
Microfinancing MFIs can reach people with a tiny income. They provide unsecured microloans. These loans assist poor women, small shopkeepers and farmers in rural regions.
These institutions are not dishonest. They have rules, they keep records, they have customer service. Such features instil public confidence in the formal finance system.
Different Types of Informal Financial System
That poor, unheard of informal financial system works entirely outside of legal oversight. It is quick and convenient, but it is unprotected. These are informal credit sources prevalent in rural areas where the people are unable to access banks.
Moneylenders
They are money lenders that charge high rates of interest. They work without papers. They are trusted to quickly grant loans. But they frequently ensnare borrowers in cycles of debt.
Friends and Family
And many borrow money from friends or relatives. It is an established practice in emergencies. Trust is the basis of these loans. They typically lack interest or legal paperwork.
Chit Funds and Committees
Chit funds are unorganised saving and loaning groups. A group of people pool money. They take turns receiving the full sum. If a member runs away, there is some risk.
Local Traders and Shopkeepers
Many small shopkeepers extend goods or cash to customers on credit. Farmers also take out loans from traders to use for seeds and fertilizer. They repay after the harvest, sometimes in crops rather than cash.
Self-Help Groups (SHGs) – Informal MFIs
SHGs are self-help groups at the village level. Women mostly run these. Members pool savings and make each other loans. Some SHGs have begun to partner with banks and semi-formal institutions.
These informal lending practices function without written terms. They assist you when the formal bank isn’t accessible. But they can be dangerous. Ambiguity in repayment rules can pressure, harass or seize the property from the borrower.
Different Between Formal and Informal Financial System
There are several distinctions between formal and informal sources of finance. People use them as per needs, location and access to services. Formal sources are safer. Common ones are fast but dangerous.
| Type | Formal Financial System | Informal Financial System |
| Regulator | RBI and Government | No regulator |
| Common Institutions | Banks, NBFCs, MFIs | Moneylenders, relatives, chit funds |
| Legal Documents | Required | Not required |
| Safety | High | Low |
| Interest Rate | Low to moderate | Very high |
| Availability | Cities, towns, growing in villages | Mostly rural and informal markets |
| Risk | Low (protected by law) | High (no legal support) |
Access and Regulation
Formal finance is a no brainer to trust. It operates under the rules of the RBI and government. Individuals fill out forms and provide identification. They issue loans upon reviewing credit history. None of this is required of informal sources. A human can get a loan without one paper. But safety is not guaranteed.
Formal finance uses banks. These banks keep your data and money safe. They give receipts. You repay using fixed EMIs. Proof does not exist in informal systems. A creditor can request repayment at any time. Often, there is additional interest charged for delays. It creates fear and stress.
Interest rates show this distinction between formal and informal finance. Banks charge 8–12% per year for loans. Moneylenders charge at least 30 percent and up. There are no rules in the informal system.
Use in Rural and Urban Areas
In cities, people primarily use banks and mobile apps. But in the villages, informal lenders are widely used. Much of rural India has no bank account. They seek fast cash from moneylenders. The informal system has a markedly larger role in the rural credit system.
Importance of Financial Institutions in Economic Development
India is made better off by the financial institutions. They include business, education, farming and health. People save money in banks. Banks lend that money out to others. This creates income and jobs. A sound financial system builds the nation.
Building Financial Security
People save with regulated financial institutions. They provide insurance and investment plans. It makes people feel secure when their money is in banks. These services help during emergencies, too. For example, a farmer can borrow money to purchase seeds. An American student can borrow money to go to college.
Chandella: Crib offers convenience by a formal credit system and easy repayment. It also eliminates the stress of sudden repayment. Moreover, people build their credit score with age. This score enables them to borrow more in the future.
Aid for Companies and Farmers
The rich want money and so do the small and big businesses. Banks provide them working capital. NBFCs provide loans to shopkeepers. Farmers get seasonal loans. These loans enable them to grow crops, earn more income. The cash circulates in the economy. That is what causes the growth and the development.
Banks also provide loans under government schemes. For example:
- PM Mudra Yojana
- Kisan Credit Card Scheme
- Stand-Up India
The schemes assist women, small businesses, and farmers. The purpose is to decrease the stress on the unorganized monetary sector.
Inclusive Finance and Digital Growth
Financial Institutions Ensure that Hands Get Access To Financial Mechanics. They are opened with zero-balance accounts. They offer online services. With UPI, even the smallest of vendors are able to use a smartphone to take payments. It reduces the need for informal credit sources.
India’s banking system now reaches to even remote villages. The advance of Aadhaar and mobile enabled individuals to check balance, transfer funds and receive subsidies directly. This reduces corruption. It lets the system build trust.
Such financial literacy programs teach people about loans, interest and savings. This means they don’t have to rely as heavily on informal lending practices.” It also draws more people into the formal system.
Relevance to ACCA Syllabus
Formal and informal financial system is essential for ACCA students as this topic connects with Financial Management (FM) paper. It teaches about financial institutions, markets and instruments, and how funds flow through various channels. It’s this familiarisation with the theoretical basis for an economy that enables us to better look at concepts of financing, managing risk, and making financial decisions — which all lie at the very heart of the ACCA syllabus.
Formal and Informal Financial System ACCA Questions
Q1. Formal financial institutions refer to organizations recognized and regulated by the government and follow certain rules and regulations.
A) Local moneylender
B) Friends and family
C) Commercial banks
D) Self-help groups
Answer: C) Commercial banks
Q2. Let me tell you the most crucial differnce between formal vs informal financial systems.
A) Formal = government-owned, Informal = private
B) formal are regulated, informal are unregulated
C) Nonformal systems tend to have lower interest
D) Money is not involved in informal systems
Answer: b) Formal systems are regulated; informal systems are unregulated
Q3. Which of the following is NOT part of the formal financial system?
A) RBI
B) Mutual Funds
C) Commercial Banks
D) Pawn Brokers
Answer: D) Pawn Brokers
Q4. Most countries have a body that actively regulates the formal financial sector.
A) Family elders
B) Trade unions
C) Central Bank
D) Self-help cooperatives
Answer: C) Central Bank
Q5. A principal drawback of informal financial systems is:
A) Low interest rates
B) Wide market access
C) Unregulated and unsafe
D) Strict documentation
Solution: C) No regulation and no secure.
Relevance to US CMA Syllabus
It falls under the External Financial Reporting and Financial Statement Analysis areas. To assess sources of financing, analyze financial structure, and calculate a firm’s cost of capital, US CMA students must be familiar with the components of the financial system. Understanding both systems, both formal and informal, helps solidify financing decisions.
Formal and Informal Financial System US CMA Questions
Q1. What of the following best describes the formal financial system?
A) Trust and social reputation based.
B) Financial channels are regulated and institutionalized
C) Interest-free peer-to-peer borrowing
D) Non-monetary exchanges
Answer: B) Financial channels that are regulated and institutionalized
Q2.Which of the following plays a crucial role in facilitating economic transactions in the absence of formal legal enforcement mechanisms?
A) Government rules
B) Social trust and informal contracts
C) Standards for financial reporting
D) Central bank monitoring
Answer: B) Social trust and informal contracts
Q3. Identify which of the following would be classified as informal financing of a small business?
A) Bank loan
B) Venture capital
C) Family loan
D) Debentures
Answer: C) Family loan
Q4. What higher risk exists in informal financial systems?
A) Audit risk
B) Currency risk
C) Credit risk
D) Legal risk
Answer: C) Credit risk
Relevance to US CPA Syllabus
Financial systems, especially a core topic in CPA BEC, are very essential for US CPA candidates. This discussions will focus on assessing sources of financing, the structure of both the product and factor markets associated with the selected business, information on the relevant regulatory agencies, and details on the nature of the relevant credit policies in all of which practicably relates to corporate finance decision-making and/or business operations relevant in scope to the CPA.
Formal and Informal Financial System US CPA Questions
Q1. The primary function of formal financial institutions is
A) Avoid documentation
B) Offer unsecured loans only
C) Turn savings into investments
D) Run unchecked by regulators
Answer: C) Mobilise savings to make into investments
Q2. What is not a part of the formal Finance system?
A) Credit rating agencies
B) Cooperative banks
C) Commercial banks
D) Informal chit funds
Ans: D) Informal chit funds
Q3. Who oversees the US financial market?
A) IRS
B) SEC
C) IMF
D) FDIC
Answer: B) SEC
Q4. Why formal financial systems are more trustworthy than informal ones?
A) Since they do not charge interest
B) Because they are based on informal rules
C) Because they work under heavy government regulation
D) Since they are faster in processing loans
Ans: C) Because they work under heavy government regulation
Relevance to CFA Syllabus
In integrate teaching on capital markets, intermediaries, and funding options across the entire CFA program curriculum, such as in Corporate Finance and Economics. Thus, the difference between formal and informal financial systems enables CFA candidates to research emerging markets, investment risk and financial inclusion policy.
Formal and Informal Financial System CFA Questions
Q1. What do we know as a characteristic of the formal financial system in developing economies?
A) Minimal documentation
B) Higher trust-based lending
C) State intervention and uniform devices
D) Lack of financial institutions
Answer: C) Government regulation and standardized instruments
Q2. Why is there an informal financial system that abounds in low-income communities?
A) Due to strict regulations
B) The prevalence of no access to formal credit
C) Interest rates are less
D) Because banks prefer them
Ans: B) Because of limited access to formal credit
Q3. Which of the following is a formal financial intermediary in the context of financial markets?
A) Goldsmith
B) Stock Exchange
C) Local trader
D) Micro-lender
Answer: B) Stock Exchange
Q4. What type of risk is normal in informal lending?
A) Regulatory compliance
B) Increased transparency of operations
C) Limited legal protection
D) Fixed return on investment
Answer: C) Give legal protection in limited ways
