Determinants of Informal Finance Use in Kenya

Abstract

Financial services sector play 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 paper examined 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 using data from FinAccess 2009 national survey. To examine the hypothesized factors, the study used Maximum Likelihood technique to estimate a logit model. The study revealed that negative attitude towards formal finance and internal business regulations play a key role in promoting informal finance use. Policy recommendations arising from the study are that formal institutions in conjunction with CBK should address negative attitude by adopting effective regulatory framework, policies and reforms leading to effective transformation of informal to formal finance. These regulations should filter favorably into informal systems allowing transformation of informal into formal institutions. In addition, formal institutions should address customer needs on a case by case basis rather than having standardized contracts that may not suit all individuals hence enhance their flexibility. They should also rein on the escalating fees and other transactions costs that enhance a negative attitude. Similarly, the CBK in conjunction with KBA and banking institutions should re-evaluate KYC requirements with a view to weeding out excessive internal regulations that drive away individuals into 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.