Entry of Formal Lenders and the Size of the Informal Credit Market

This paper models the formal-informal interaction that is typical of LDC credit markets characterised by financial duality. It considers the effects of free entry of formal lenders on the size of the informal credit market. We show that free entry by formal lenders increases their reach to collateral-poor borrowers. However, strategic interaction with informal lenders reduces the effectiveness of free entry in curbing informal lending if the formal administered interest rate is high. Free entry cannot eliminate the informal credit market altogether, although it will be more effective than deregulation of the interest rate.