World Development, Vol. 20, No. 3, pp. 423-436,1992. 0305750X/92 $5.00 + 0.00 Printed in Great Britain. 0 1992 Pergamon Press plc Segmentation in Rural Financial Markets: The Case of Nepal S. YADAV* University of Minnesota, St. Paul K. OTSUKA Tokyo Metropolitan University and C. C. DAVID International Rice Research Institute, Manila Summary. - Based on a farm household survey in Nepal, this study found that farm size and irrigation are major determinants of borrowing from formal institutions, whereas family size is the most decisive factor in borrowing from informal sources. Formal sector borrowing per hectare of cultivated area, however, initially increases and then decreases with farm size. Our analysis indicates that while very small farmers tend to be excluded from the formal financial market because of a lack of collateral, very large farmers choose to borrow less from that source because of lower production efficiency. 1. INTRODUCTION The rural financial market is composed of several distinct submarkets: a formal and various segments of an informal sector. Lenders in the formal sector are credit institutions managed or regulated by the government, whereas informal credit sources include professional money- lenders, relatives and friends, traders, and land- lords. Terms and conditions of credit contracts among these sources are known to be markedly different, ranging from cheap, subsidized institu- tional loans with strict collateral requirements to usurious loans from moneylenders. As has been argued in recent literature, prob- lems of adverse selection and moral hazard arising from the inability of lenders to identify repayment abilities of borrowers and to enforce the appropriate use of loans cause difficulty to lenders.’ This is particularly the case with formal lending institutions, for which the high cost of acquiring borrower-specific information coupled with the excess demand created by subsidized interest rates lead to greater concentration on production loans with a collateral requirement to ensure loan repayment. Such requirements, however, exclude asset-poor, small farmers from the formal sector. In contrast, informal lenders can charge higher interest rates, incur lower administrative costs, and link credit to labor, land and output markets, lowering the cost of risk and transactions. Informal lenders also have more information about the borrower’s capacity and willingness to repay loans. Relatives and friends, in particular, can better enforce repay- ment because of the potential threat to the borrower’s reputation within the family circle in the event of defaulting.’ Thus, the informal sector tends to provide more consumption loans without explicit collateral, that may not bear tangible future returns. These considerations represent a consistent explanation for the exist- ence of various submarkets in the rural financial market. Economists have long recognized such diver- sity in the rural financial market and the unique- ness of the different categories of credit contracts (e.g., Bottomley, 1963; Long, 1968a, 1968b). Yet until recently, empirical studies focused on the analysis of the formal credit market (Von Pischke, Adams and Donald, 1983; Braverman *This study draws heavily on a MS thesis by Yadav (1989). 423