The traditional approach to financial development, the financial repression approach (McKinnon, 1973 and Shaw, 1973), can be characterised by its concentration on the formal sector and relative neglect of the informal sector. This tendency stems from the fact that the proponents of financial repression approach do not view informal credit markets as an alternative source of financing in developing countries. They further hold the view that informal credit markets in developing countries grow under conditions of financial repression. Their general policy recommendation, removal of financial repression or alternatively financial liberalization, is regarded as accomplishing two desirable outcomes: financial deepening and reducing the activities of the informal financial sector in developing countries.
The informal sector, however has proved more resilient than the financial repression approach has assumed. Even in liberalised financial system along with the formal sector, there continues to exist a heterogenous and dynamic informal sector (Ghate, 1992, 859). This shortcoming of the financial liberalization approach has been addressed by the new institutional economics approach. The principal contribution of the new institutional economics approach (Stiglitz and Weiss, 1981; Foloro and Yotopoulos, 1991) has been to provide a framework that can capture the complexity of credit relationships and institutions in developing countries.
The new institutional economics approach is based on the premise that market failures are pervasive in the economy (Stiglitz, 1991, 22). The basic forces leading to market failures, in the new institutional perspective, are costly and imperfect information. The new institutional economists have contended that alternative credit institutions in informal financial markets, such as interlinked contracts, operating on the basis of personalized relationships can reduce these informational problems. This study examines the informal financial institutions in Iran within the framework provided by the new institutional economics approach.
The informal credit markets in Iran have a long history1. Historically, money-lending activities in Iran have been situated in bazaars of major cities and considered as an important source of finance especially for businesses within the bazaar. One unofficial estimate in the 1970s put the number of moneylenders in the bazaar at several hundred individuals controlling approximately 15 percent of the private sector credit (Graham, 1980, 224). Elaborating on the significance of the funds supplied by the informal markets in the bazaar, Alan D. Urbach and Jurgen Pumpluen (1978) have commented that the most widely accepted 1975 estimate of 20 percent of the official market volume "could mean upwards of $3 billion in foreign exchange and $2.1 billion in loans outstanding, figures not contradicted by the Central Bank" (Urbach and Pumluen, 1978, 117). Although more recent estimates of the size of the informal sector are not available, the rise in relative importance of the informal sector2 in the post-revolutionary period suggest that the significance of the informal financial markets has become more pronounced.
This study examines three issues within the framework provided by the new institutional economics approach. Within the new institutional economics informal institutions in less developed countries are viewed "as a response to informational considerations and inequality in the distribution of wealth" (Braverman and Stiglitz, 1989, 185). In line with the new institutional economics it will be argued that the continuity and resiliency of large scale informal credit market activities in the bazaar are due to the sociocultural aspects of the bazaar, which provide the informal credit markets with the necessary market infrastructure. More specifically it will be argued that the communication networks in the bazaar facilitates the transmission of information and in that manner provide for better assessment of credit worthiness
The second issue that will be examined is the significance of reputation in credit relationships in the bazaar. According to the new institutional economics, the personal relationships and the wide variety of interlinked contracts are ways of dealing with imperfect information and incentive problems that are prevalent in the capital markets. Within the new institutional economics paradigm reputation is perceived as a type of interlinked contract since it links the future access to credit to current behaviour. The new institutionalists' studies show that reputation can reduce the incentive problems in credit markets (Diamond,1989). This study will examine the contribution of interlinked contracts through assessing the significance of reputation in credit relationships in the bazaar.
Third, the issue of linkages between the formal and informal sectors is examined. In the traditional view there is little interactions between the formal and informal sectors. Various studies3 of informal financial institutions in developing countries, however, have contradicted the traditional view on this issue. The research indicates that informal lenders have access to banks or, in the reverse direction, informal lenders deposit their funds at the banks. The new institutional economics complementarity hypothesis explains the existence of links by suggesting that the formal and informal sectors, due to their differential comparative cost advantages, essentially cater to different segments of the financial markets. While banks cater to less risky borrowers with adequate collateral, informal institutions lend to higher risk borrowers with no collateral. The outcome of this proposition according to the new institutional economists is the prevalence of credit-layering across the two markets.
The organization of this article is as follows. To explore the theoretical underpinning for the significance of informal credit market activities within the bazaar, the second section examines anthropological studies of the bazaar. Subsequently a survey of the literature on the bazaar in Iran demonstrates the contribution of sociological aspects of the bazaar to widespread credit relationships in the bazaar. In the fourth section the significance of reputation for reducing the incentive problems in credit transactions in bazaar is assessed. In the fourth section the presence of linkages between the formal and informal sectors are investigated. Finally in the last section the findings are summerized.
Informal Credit Markets in the Bazaar
The Iranian bazaar is a collection of shops and stalls in covered and open alleyways which spreads over several kilometers and split up into different trades. Drawing on anthropological studies, this section illustrates that informal credit market activities are an integral part of the bazaar system
Due to the presence of peasants in both peasant markets and in the bazaar, in anthropological studies the term bazaar economy has sometimes been used to refer to peasant markets. Charles T. Thompson and Marilyn J. Huies (1968), drawing on various surveys of markets including Thompson's own observations of the functioning of bazaar in Iran have identified the areas where "Peasant Marketing Systems" and "Bazaar Marketing Systems" Informal Credit Markets in the Bazaar differ. Two of the distinguishing features of "Bazaar Marketing Systems" that are particularly relevant to the present discussion are: (1) "exchange of goods is vertical between a bulker/wholesaler/merchant and the customer (largely urban)", and (2) "credit and capital are vital to the functioning of the system" (Thompson and Huies, 1968, p.225).
More significantly, the authors contend that the former feature implies the latter. In other words, the exchange of goods through a chain of middlemen in the "Bazaar Marketing System" is dependent on a broad network of credit relationships. "Whereas the peasant system does not depend upon capital or resource to capital through credit, the bazaar system is dependent upon it. The formation of credit relationships among middlemen not only allows the functioning of small merchants, but insures the smooth flow of goods from the wholesaler through the merchants to the ultimate consumers by maintaining a wider and more continuous (spatial and temporal) network of exchange than the peasant system (Thompson and Huies, 1968, 223)”.
Thompson and Huies's description of the significance of credit relationships in the bazaar system highlights the importance of future commitment. They argue that the types of credit relationships that exist in the bazaar are long-term relationships. Further stressing the permanent nature of credit relationships they argue that the "complex balance of carefully managed credit relationships within the Bazaar Marketing System"... "provide a measure of flexibility that is needed in an economy" that is "rather unstable and unpredictable in terms of long-range profits and losses (Thompson and Huies, 1968, 222)”.
Thompson and Huies explanation provide a rationale for exchange relationships from the perspective of merchants/traders. Clifford Geertz's theoretical study of the bazaar economy provides a rationale from the perspective of customers. Overall, Geertz's study highlights the role of information, communication, and knowledge in understanding how the bazaar works. The principal message of Geertz's work is that information is seriously lacking in bazaar and, as such, the activities within are bazaar better interpreted as attempts to bank on other people's ignorance. "The level of ignorance about everything from product quality and going prices to market possibilities and production costs is very high, and much of the way in which the bazaar functions can be interpreted as an attempt to reduce such ignorance for someone, increase it for someone, or defend someone against it (Geertz, 1978, 29)”.
Therefore, according to Geertz clientelization or personalized exchange relationships is one procedure used in bazaar to reduce the search costs. "[C]lientelization itself lends form to the bazaar for it further partitions it, and does so in directly informational terms, dividing it into overlapping subpopulations within which more rational estimates of the quality of information, and thus of the appropriate amounts and type of search can be made (Geertz, 1978, 31)”.
Drawing on anthropological studies, this section illustrated that informal credit market activities are an integral part of the bazaar system. More specifically, the discussion in this section suggested that credit relationships minimize risks, optimize predicability, and reduces information costs in bazaar. Furthermore, the survey of anthropological studies on the bazaar provided rationale, on the basis of risk aversion and information costs, for the prevalence of credit relationships within the bazaar. In the following section the contribution of socio-cultural aspects of bazaar in Iran to widespread credit relationships are explored.
Communication Networks in the Bazaar
Historically, moneylenders in Iran have been situated in bazaar of major cities and considered as an important source of finance especially for businesses within the bazaar. This financial independence from the banking system, especially at times of crisis, has proven to be an important source of strength for the bazaars . In turn, moneylenders in the bazaar benefited from the existing communication channels within the bazaar to conduct their business. The Urbach and Pumpluen discussion highlights the significance of dissemination of information for informal money lending activities in the bazaar. They comment “[i]nformation and its quick dissemination are the essence of a money lender's security. Word spreads so quickly that a merchant turned down independently by two lenders is confronted by a third with this knowledge within the hour (Urbach and Pumpluen, 1978, 115)”. The significance of the communication channels, bears further elaboration.
The bazaar is much more than what it appears to the casual observer, a shopping area. The Iranica encyclopedia gives the following, all encompassing, description of the bazaar. “The urban bazaar was the central business district of the cities in the Iranian cultural area. But it was far from being just a marketplace. The bazaar was and still is a social institution, comprising religious, commercial, political and social elements (Yar-shater, 1990, 25)”.
Furthermore, Gustav Thaiss has argued that the cultural and social aspects of the bazaar support the smooth transmission of information within the bazaar. The restaurants, tea houses, gymnasiums, and bathhouses are places in the bazaar where people meet and exchange information. The bazaar population participates in socio-religious events and festivals and the social aspects of the bazaar are particularly apparent in the joint prayers of traders in mosques, many of which are in or near the bazaar. In addition to daily prayer, the bazaar community participates in the weekly religious gatherings. The social and cultural aspects of the bazaar form the basis for the mass communication networks. “It is through these interpersonal networks and the participation of the same individuals in several different gathering during the week that bazaar information, ideas, and rumors are passed on (Thaiss, 1971, 189)”.
It has also been argued that the traditional channels of communications in the bazaar had out-competed the modern mass communication network that the Pahlavi regime had under its control (Mowlana, 1979). In the pre-revolutionary period, the dominant culture portrayed in the conventional mass media had become alien to the majority of the population. As a result people were drawn to the traditional means of communications such as the bazaar which is “ an important center of news, a place where opinions are formed and from which rumors are spread over wide areas with almost incomprehensible speed (Mowlana, 1979, 109)”.
A significant characteristic that facilitates the functioning of the information networks is the particular structure of the bazaar . Regarding the impact of the structure of the bazaar on its role in mass communication, Misagh Parsa has commented that “[i]n most major cities, the central bazaars are concentrated in a single location, in many alleys under covered roofs. The concentration and proximity of shops facilitate communication (Parsa, 1989, 92)”.
This is in spite of the fact that bazaars in major cities are quite extensive and occupy a large area. The number of shops in Teheran's central bazaar, in the late 1970s, was close to forty thousand shops and workshops. One-half of these were located within the covered bazaar with the remainder in the immediate vicinity (Parsa 1982, 92).
The existence of these channels of communications within the bazaar has allowed this institution to play an important role in political conflicts. Historically the significance of the bazaar as a meeting place at which people spread their messages and organized their resistance was manifested “[i]n the movement against the tobacco concession of 1882, the constitutional revolution of 1905-11, the nationalization of oil and the Mossadegh era of 1950-53, and Ayatollah Khomeini's 1963 campaign against Mohammah Reza Shas Pahavi. (Mowlana, 1979,109)”.
Parsa has further commented that, more recently, bazaaris "were at the forefront of the conflicts against the Shah" and "of primary importance in bringing down the Pahlavi regime (Parsa, 1989, 92)”.
In summary the survey reveals that the existence of communication networks facilitate the transfer of information within the bazaar. This observation corresponds to the new institutional economics perspective on various institutions and mechanisms within the informal sector. Concurrently, in line with the new institutional economics it can be argued that the continuity and resiliency of informal credit market activities in the bazaar are due to the sociocultural aspects of the bazaar, which provide the informal credit markets with the necessary market infrastructure. One element emphasized here is the existence of communication networks in the bazaar, i.e., the communication networks facilitates the transmission of information and in that manner provide for better assessment of credit worthiness.
Importance of Reputation in the Bazaar
According to the new institutional economics the wide variety of interlinked contracts in developing economies' capital markets are ways of dealing with the prevalent imperfect information and incentive problems. In this section it will be argued that credit relationships in the bazaar are interlinked contracts which involve future reciprocal commitment. More specifically the description of credit contracts offered by merchants and moneylendes, in this section, suggest that there is linking of future access to credit to current behavior in which reputation is paramount.
Focusing on the Qazvin bazaar Howard J. Rotblat observes that there are two types of credit contracts: credit extended to customers by retailers in order to purchase high priced items such as carpets or jewellery and credit extended to merchants by other merchants. In the case of credit extended to customers by merchants, credit was extended especially for items such as clothing for which there was a regular demand requiring frequent interaction between shopkeepers and customers, thereby establishing a fiduciary relationship. Regarding the charges for the use of credit, they to some extent "follow the rate structure used by Bazaar moneylenders for commercial loans with a maximum interest rate of approximately 25 percent" (Rotblat, 1972, 202). However they were "intimately tied to the degree of closeness in the customers merchant relationship, and therefore interest in the usual sense is only one factor in determining the terms of a transaction in which payment is deferred" (Rotblat, 1972, 203).
And in regard to credit extended by merchants to other merchants, although the means for extending credit, as with cases involving customers and merchants, is predominantly post-dated checks, the use of these checks between merchants differs (Rotblat, 1972). That is merchants usually use the post-dated checks they receive from other wholesalers to get credit from other bazaaris. This situation, consistent with the view expressed by Thompson and Huies, gives rise to a complicated credit relationship among merchants.
Beside merchants, credit in bazaar is also extended by moneylenders. In credit contracts offered by moneylenders no collateral is involved and the penalty of default is damaged reputation. Regarding the moneylenders' operations Urbach and Pumpluen have described that “[t]hese gentlemen traditionally operate without fixed abode. Few of the 100-150 money lenders in the Teheran bazaar have business addresses either. Most transactions take place in an informal manner amid the noise and passers-by. Despite the seeming infrastructural paucity the parallel money market is as sophisticated as is the official one, and maybe more so (Urbach and Pumpluen, 1978, 115)”.
The contract involved links the future access to credit to current behavior. Urbach and Pumpluen have commented that “[m]oney lenders are the entrepreneurs of the bazaars; ears tuned to the whispers, eyes alert during their frequent visits to a merchant's shop. A loan turns on a man's reputation and is collaterized by his signature on a safte, the Iranian equivalent of a promissory note (Urbach and Pumpluen, 1978, 115)”.
Overall, the survey of various credit transactions in bazaar, suggests that credit transactions commonly occur in circumstances in which the agents involved had frequent interactions or that they had an established relationship, so that reputation could play a role. As was mentioned before, the new institutional economics theoretical studies of reputation have shown that reputation can be a strong enforcement device since the significance attached to reputation by linking future access to credit to current behavior exert pressure for repayments.
The significance of reputation in bazaar emphasized by Potkin A. Basseer (1972) in his discussion of different borrowers in bazaar. He identifies borrowers as merchants, customers, real estate developers, and also small manufacturers. He further adds the large-scale entrepreneurs to that list who as he descried "borrowed consistently from the bazaar in order to maintain their name in the bazaar in the event of a credit squeeze by the regulated financial intermediaries"(Basseer, 1982, 195).
The examination of the credit operation in the bazaar further reveals the importance attached to reputation. The note used in making credit extensions in the bazaar, softeh, is an unsecured promissory note drawn for a short period (usually 90 days). Richard E. Benedick (1964) argues that the most important element of softeh from the point of view of lenders is the signature(s) on the loan and that borrowers can purchase the co-signature of a reputable person for a price. Moreover borrowers can be charged three different rates depending on their reputation and credit worthiness. Furthermore commenting on the viability of sarrafs' (moneylenders) operations Benedick argues that the system is vulnerable because as he puts it "the signer of a softeh is trading on his general credit reputation (Benedick, 1964, 68)”.
The survey of various credit transactions demonstrates the significance of reputation. The significance of reputation in bazaar for reducing the incentive problems in credit transactions is further illustrated because in none of the situations examined collateral was involved.
Interlinkages between the two Sectors
According to the new institutional economics in developing countries the absence of appropriate market infrastructure constrains the operation of the informal credit markets. As Sagrario L. Floro and Pan A. Yotopoulos have stated “in many developing countries poverty makes the availability of collateral rare and ill-defined property rights and underdeveloped legal infrastructure make the acceptability of collateral questionable” (Floro and Yotopoulos, 1991, 44). Thus there is a credit gap in formal credit allocation, due to an infrastructural vacuum, which the informal credit markets in developing countries fill. Within this framework the formal financial sector specializes on the prime or most bankable risks and the informal sector accommodates the residual demand for credit. In other words, the relationship between the two sectors are complementary.
Complementarity hypothesis signifies the existence of asymmetry in credit distribution of formal financial institutions and different areas of concentration for the formal and informal sectors. However, complementarity can also exist when there are linkages between the two sectors (Ghate, 1992). Indeed, Floro and Ray (1996) suggest that the degree of linkages between the two sectors is indicative of degree of complementarity between the two sectors (Floro and Ray, 1996, 5).
To explore the linkages between the two sectors in Iran, the activities of sarrafs in urban areas should be assessed. Sarrafs are the main agents in bazaar involved in informal moneylending activities. Sarrafs, in addition to extending working capital to the trade sector also lend money to households and to small scale manufacturers. Describing finance in the bazaar, Basseer observes that sarrafs' sources of capital were"... (1) the periodic cash released from inventories, (2) placements by other merchants and households seeking higher returns than the organized financial markets, and (3) funds borrowed from the organized financial intermediaries (Basseer, 1982, 194)”. Other sources concurrently have indicated that, since the beginning of the banking operation in Iran, borrowing from the banking system has been an important source of funds for the sarrafs (Iran Almanac, 1968, 431). In other words, this observation suggest that ever since the establishment of the banks in Iran, sarrafs have been taking advantage of the arbitrage opportunities thus created by borrowing from the banks and relenting at higher rates of interest in the informal sector.
The existence of links between the two sectors is also revealed from Reza Najafbagy's discussion of money lending in Iran. He writes “despite the development of banks, moneylending is still powerful in Iran. In Teheran alone, there are about 3,600 large and small money lenders. Of these about 200 are big money changers, each having a capital of more than Rls. 10 million ($131,600). Under the banking laws of Iran, banks are not allowed to lend money to money lenders, but some of the money lenders engage in businesses in order to get credits from banks, and other money lenders have such large deposits in banks that if they withdraw them they could shake these banks (Najafbagy, 1970, 125)”.
Some specific evidence on the points of contact between the two markets is that “[l]ocally, several major banks, including, it is said, the government-owned Bank Melli (the largest bank in Iran ), lay off excess funds with the bazaari lenders. This is done by direct lending or by rediscounting saftes (Urbach and Pumpluen, 1978, 117)”.
They further argue that in Iran the informal credit markets intermingles with the formal interbank market. They explain this outcome by claiming that in Iran“[t]he major banks prefer to fund the parallel market as they fear that by helping the smaller banks through a formal interbank market the latter will lure their own customers away. This is probably true, given the low level of service offered by the larger banks (Urbach and Pumpluen, 1978, 117)”. Moreover, they explain that“[b]azaari dealers do not compete and they even return the favour by putting their classical banking business through the majors. Bazaari funds also find their way through these banks to become deposits in the international markets ( Urbach and Pumpluen, 1978, 117)”.
As was mentioned before, the new institutional economics complementarity hypothesis implies that the formal financial institutions concentrates on prime risks and leave a large vacuum in the credit markets for the informal credit markets to fill. Examination of the interaction between the two sectors provided evidence of complementarity in terms of linkages between the two sectors, as well. The asymmetric distribution of credit by the two sectors is explained by differences in comparative cost advantages between the formal and informal sectors. These comparative cost advantages also explains the presence of linkages between the two sectors. The existence of linkages between the two sectors, in turn, provides an explanation for the continuity and persistence of the informal credit markets in Iran.
In this article the significance of communication networks and interlinked contracts in reducing the costs of information and enforcement in the bazaar was examined. The emphasis on the communication networks and interlinked contracts, for reducing the transaction costs associated with the informal credits is consistent with the new institutional economics. Floro and Yotopoulos (1991) have shown that alternative credit arrangements in informal credit markets operating on the basis of personalistic relationship can reduce information and enforcement costs. Similarly the survey of various conventions, information networks and interlinked contracts, in this article, demonstrated that personalized relationships form the basis for social and economic interactions in the bazaar.
Furthermore, the survey of the operation of the informal credit markets revealed the presence of linkages between the formal and informal sectors. The new institutional economics complementarity hypothesis explains the existence of links by suggesting that the formal and informal sectors, due to their differential comparative cost advantages, essentially cater to different segments of the financial markets. The presence of linkages between the two sectors, in turn, explains the resiliency of the informal credit markets in the bazaar. In sum, consistent with the new institutional economics, this study suggest that these categories fit the reality in the case of Iran.