The modem approach to informal finance seeks to exploit the comparative advantage of informal financial institutions (Yaron, _et. al,_ 1997). Reforming the financial sector in developing countries should aim at strengthening the complementarity between formal and informal sectors. Formal financial institutions who do not find uneconomical to deal with informal borrowers directly could operate through informal lenders; these would act as second-layer intermediaries: large pools of small savings could be placed in formal financial institutions and thus benefit from greater diversification and higher returns. Similarly, savings from the formal sector would flow into informal-sector projects, something that would not normally happen. While formal institutions could lend to the second-layer intermediaries against collateral, end-borrowers may not have to pledge collateral. A well consolidated example of such form of complementarity is offered in India by the non-banking financial companies sector (IPahwa, 1998).

Another important advantage of any informal-formal link is that formal financial institutions would have an incentive to select the best informal service providers, and so eliminate the low-quality ones from the market. The franchise value of those informal providers doing business with formal institutions will increase Indeed, they would seek out ties with the formal sector, a powerful incentive to strengthen their reputational capital by serving their community fairly and efficiently. One example of successful links between the formal and the informal sectors is offered by the monyeshops in the Philippines (Von Pischke, 1991).

Infornal financial service providers must be able to price their services consistently with the need for a fair return on the risks taken, and should be permitted to offer saving- and transaction-services to their customers (for instance, saving and deposit accounts, money transfers and payment services). Such services would enhance the information content of the relationship between the service provider and her end-users, as they convey more information on the income and payment time-profile (and, ultimately, on creditworthiness) of the loan customers, and supply end-users with means to test the reliability and accessibility of providers. In close communities, saving and transaction services increase the loan customers' incentive to repay their loans, knowing that loans effectively come from their neighbors rather than distant, anonymous agencies (Vogel, 1984). Furthermore, these services contribute to the formation of larger financial savings by inducing small rural savers to convert their accumulated tangible stores of value (jewelry, livestock, cash) into higher-yielding and more liquid financial assets. By doing so, they add to the liquidity of the economy.

The government could also induce informal self-policing in rural and urban communities, where ethnic bonds are stronger and some local leaders have a high reputation, by exploiting the opportunity for low-cost information sharing and peer-pressure mechanisms that are typical of small communities. Through peer-monitoring informal self-policing would improve considerably the borrowers' debt- repayment capacity and lower transaction costs associated with lending to informal borrowers (Stiglitz, 1993). Government should seek to gain firsthand knowledge of developments and conditions in the informnal sector through regular direct contacts with the local communities of informal service end-users and through _ad hoc_ surveys and research activity. Government should sanction informal providers who imposed unfair and exploitative terms on loan and service customers, or endangered the trust basis of their communities, and should ensure viable conditions for those who maintain a high reputational capital and serve their community well.

In the longer term, incentives in the informal financial sector would strengthen the domestic base of savers and borrowers, and increase the quality of resource allocation and use in those parts of society otherwise condemned to stagnation and poverty. Government should thus refrain from imposing plans that defy economic incentives like, for instance, forcing formal 40