Deregulation in the formal credit market and its impact on informal credit

This paper analyses the effects of deregulation of formal interest-rate in terms of a model of strategic interaction between the formal and the informal lender, in which borrowers are differentiated in terms of their capacity to pay collateral. The formal lender is subject to interest-rate ceiling and faces the possibility of strategic default. Strategic default by the entrepreneur is however not possible in case of the informal lender, as the informal lender can fully observe the entrepreneur. It is shown that there is a range of interest- rates such that if the interest-rate ceiling lies in that range then deregulation of the formal interest-rate will cause informal lending to expand and formal lending to contract. This is in contrast with the conventional wisdom that in the face of interest rate deregulation formal lenders always gain in market share.