Interest Rate Caps, Relationship Lending, and Bank Competition: Evidence from Bangladesh

Working Paper
Published on 10 November 2017
Yuhei Miyauchi


Miyauchi (2017) studies the short and long-term impacts of the interest rate caps on loans for large and medium-sized manufacturing enterprises introduced in 2009 and lifted in 2011 and 2012 in Bangladesh. Using the branch-level variation of pre-regulation interest rates and loans for consumer goods as placebo, the author finds that the introduction of the interest rate caps significantly increased the aggregate outstanding loans at the branch level. In particular, a 1 percentage point increase in pre-regulation interest rates induced a 17% increase in outstanding loan amounts and an 11% increase of the number of outstanding loans one year after the onset of regulation. Strikingly, this increase persisted after the regulation was lifted. The persistence of the policy's impact after its removal is consistent with a model of relationship lending, where banks with market power face borrowers of unknown types over multiple periods. In such an environment, banks "under-experiment" on borrowers by setting high interest rates without the interest rate cap, while the cap "forces" banks to experiment on more borrowers. This supplies banks with information about more borrowers ex-post; hence the credit supply and the per-period profit increase after the cap is lifted. Overall, the results suggest that there is a distortion in the banking market in Bangladesh due to under-experimentation and insufficient competition, and that the lending rate caps were effective in resolving it.