Economic Research Forum (ERF)

Financial informality among formal firms: evidence from Egypt

A significant number of small and medium-sized enterprises stay disconnected from credit markets even after they become formal firms – a state that can be characterised as ‘financial informality’. Access to credit is valuable for firms with substantial growth opportunities, but it can become more difficult to hide revenues from the tax authorities. This column, originally posted on the GlobalDev blog, explores the characteristics of firms and local credit markets that affect this trade-off in Egypt – and potential policies for greater financial inclusion of unbanked firms and those discouraged from applying for loans to fund investment.

In a nutshell

Financial informality among formal firms can occur even among those with a bank account: this happens when they are discouraged from applying for a loan to finance investment.

Crowding out limits the supply of loans to firms with bank accounts; and support schemes that operate via the formal credit market may have difficulties reaching firms that remain financially informal.

Reform of the business environment and improvements in managerial skills, which in turn increase the opportunity costs of remaining unbanked, are complementary to traditional interventions aimed at increasing the supply of credit.

Informality is widely recognised as a key factor limiting growth in developing countries. But recent empirical evidence shows that firms may reap limited benefits from formalising themselves. One of the main advantages of formality is better access to finance.

Nevertheless, this advantage is worth little if registered firms remain disconnected from formal credit markets. These firms are less likely to exploit the investment and growth opportunities that come with access to credit. In a recent study, we find that this is very common among small and medium-sized enterprises (SMEs) operating in Egypt. We refer to this state as financial informality among formal firms.

Financial informality can take at least two forms. The first form is that firms may refrain from having a saving or checking account, and instead rely solely on cash transactions. That in turn can gravely limit their access to the formal financial system.

Having a checking account is important for access to finance because it allows a bank to monitor inflows and outflows, and thereby reduces the information asymmetries that plague lending to small firms. In particular, account information helps the bank to establish reliable turnover and cash flow figures, which in turn is crucial for creating rudimentary financial statements.

Figure 1 shows that being unbanked is widespread among Egyptian firms. Only 60% of firms had a checking or saving account in 2013, with the proportion increasing to 69% by 2016.


Figure 1. Account penetration in Egypt and around the world, by country

Source: Enterprise Surveys.


Account penetration in Egypt is low, but the country is by no means an outlier. Countries with lower account penetration include Vietnam, Pakistan, and the Democratic Republic of Congo, to name just a few with large populations.

We find that having a bank account depends on the characteristics of senior managers. In particular, bringing in a more educated and more experienced chief executive raises a firm’s propensity to open a bank account. These results can be partly explained by financial literacy among managers.

But we also find that firms run by more educated managers are more likely to have a website, to innovate, and to have expansion plans. This suggests that organisational capital arising from managerial skills and experience can also support financial inclusion by raising the opportunity costs of remaining unbanked.

Appropriate policies include measures that enable a more dynamic private sector overall, such as low barriers to entry and a playing field that is not tilted in favour of politically connected firms. Education reform can also bring benefits over the longer term. In contrast to traditional interventions that seek to increase the supply of credit, such policies would work through the demand side of the market.

The second form of financial informality among formal firms can occur even among those with a bank account. This happens when they are discouraged from applying for a loan to finance investment. The decision not to rely on formal credit may be more likely if the intermediation capacity of the banking system is weak and the likelihood of being credit-rationed is high. We examine this hypothesis by studying the impact of the drastic increase in public debt between 2013 and 2016, which crowded out private lending to SMEs.

Figure 2 shows that the share of public debt in the balance sheets of banks increased substantially after 2011. But banks differ in the extent to which they accumulate government debt. Making use of data on the location of bank branches in Egypt, we find that firms become more exposed to crowding out when they are located near to branches of banks that invest more heavily in government debt. The exposed firms become less likely to apply for bank loans when they need one due to an unexpected liquidity shock.


Figure 2. Government borrowing from local banks in Egypt, 2010-17

Source: Authors’ calculations based on Central Bank of Egypt.


It turns out that our results are mainly driven by public banks and their higher tendency to accumulate government debt. Publicly owned banks play an important role in credit markets of developing countries, accounting for 71% of total assets in Ethiopia, 67% in India, 61 % in China, and more than 40% in large Latin American countries such as Argentina and Brazil.

Publicly owned banks are particularly crucial in serving areas that are financially less developed. Given their importance, our results provide novel insights on the link between the intermediation capacity of the financial system and the limited demand for formal lending among registered firms.

This has important implications for the period of economic recovery following the outbreak of Covid-19. Public debt has increased sharply to cushion the negative impact of the pandemic on the economy. Higher refinancing needs combined with heightened risk aversion among investors may drive up interest rates and crowd out lending to the private sector.

The authorities need to take account of the implications for the intermediation capacity of the banking system and the financing conditions of the private sector:

  • First, crowding out limits the supply of loans to firms with bank accounts.
  • Second, support schemes that operate via the formal credit market may have difficulties reaching firms that remain financially informal.

Over the medium to longer term, policy-makers need to recognise that reform of the business environment and improvements in managerial skills, which in turn increase the opportunity costs of remaining unbanked, are complementary to traditional interventions aimed at increasing the supply of credit.


The opinions expressed in this column are those of the authors only and do not necessarily reflect those of the European Investment Bank.

This column was first published on GlobalDev.


Most read

Sustaining entrepreneurship: lessons from Iran

Does entrepreneurial activity naturally return to long-term average levels after big economic disturbances? This column presents new evidence from Iran on trends in entrepreneurship among various categories of firm size, sector and location – and suggests policies that could be effective in promoting entrepreneurial activities.

Happiness in the Arab world: should we be concerned?

Several Arab countries have low rankings in the latest comparative assessment of average happiness across the world. But as this column explains, the average is not a reliable summary statistic when applied to ordinal data. The evidence from more robust analysis of socio-economic inequality in happiness suggests that policy-makers should be less concerned about happiness indicators than the core development objective of more equitable social conditions for citizens.

Financial constraints on small firms’ growth: pandemic lessons from Iran

How does access to finance affect the growth of small businesses? This column presents new evidence from Iran before and during the Covid-19 pandemic – and lessons learned by micro, small and medium-sized enterprises.

The economics of Israeli war aims and strategies

Israel’s response to last October’s Hamas attack has led to widespread death and destruction. This column outlines the impact thus far, including the effects on food scarcity, migration and the Palestinian economy in both Gaza and the West Bank.

It’s too early to tell what happened to the Arab Spring

Did the Arab Spring fail? This column presents a view the consensus view from ERF’s recent annual conference in Morocco: careful analysis of the fundamental drivers of democratic transitions suggests that it’s too early to tell.

Arab regional cooperation in a fragmenting world

As globalisation stalls, regionalisation has emerged as an alternative. This column argues that Arab countries need to face the new realities and move decisively towards greater mutual cooperation. A regional integration agenda that also supports domestic reforms could be an important source of growth, jobs and stability.

Gender differences in business record-keeping and planning in Iraq

Only one in every ten informal businesses in Iraq is led by a woman. Yet as research summarised in this column reveals, those businesses are more likely to set budgets and sales targets, and to keep business records. This may be evidence of the role of social exclusion in motivating greater reliance on the formal bureaucratic system.

Self-employment in MENA: the role of religiosity and personal values

How important are individual’s values and beliefs in influencing the likelihood that they will embrace the responsibilities, risks and entrepreneurial challenge of self-employment? This column presents evidence from 12 countries in the Middle East and North African region on the roles of people’s religiosity and sense of personal agency in their labour market choices.

Reformed foreign ownership rules in UAE: the impact on business entry

In an effort to stimulate economic growth and diversify the economy, the government of the United Arab Emirates has recently implemented regulatory reform that allows 100% foreign ownership of companies operating in the country. This column examines the implications of the reform for entry of new firms in Dubai, using unique data on new business licences in the emirate.

Conflict and debt in the Middle East and North Africa

With the global economy is in its third year of deceleration amid declining inflation and oil prices, the Middle East and North Africa grew by just 1.9% in 2023, with a forecast for growth in 2024 at 2.7%. In addition to heightened uncertainty brought on by the conflict centred in Gaza, many countries in the region are also grappling with pre-existing vulnerabilities, including rising debt levels. This column summarises a new report that unpacks the nature of debt in MENA – and explains the critical importance of keeping rising debt stocks in check.