Interest Rate Caps in an Economy with Formal and Informal Credit Markets

In this work, we aim to study the implications of the interest rate cap in an emerging economy. To do so we develop a two-period banking model with entrepreneurs that undertake risky projects and with formal and informal lenders. Entrepreneurs are heterogeneous in their level of net worth. We find that a cap on the lending interest rate excludes entrepreneurs with a low level of net worth, which in turn increases the participation of the informal credit market, but also might reduce bank markups increasing entrepreneurs' welfare. Our findings imply that the lower the market power of banks, the smaller the likelihood that the cap might have some positive impact on aggregate credit and investment. Furthermore, we suggest that the lower the financial inclusion and the higher the asymmetric information problem, the higher the likelihood of caps harming the economy, due to caps preventing clients to create a good credit history and improve their credit conditions.