Arnold Kling recently gave a brief overview on how the formal and informal sectors of finance relate to each other.

We can think of financial institutions as lying on a continuum somewhere between informal and formal. At the formal end of the spectrum, institutions are adjacent to the government. At the informal end of the spectrum, institutions are adjacent to criminal activity…

In short, institutions that are distinct from the formal sector can reach customers that the formal sector will not serve. Informal institutions can compete away some of the excess profits of the formal sector. But an advanced economy still depends heavily on the formal sector. The benefits provided by letting the informal sector expand should be weighed against the costs of undermining the formal sector.

As the informal sector displaces the formal sector, unexpected outcomes occur. New regulatory responses are created and the game starts over.