Vertical linkage between formal and informal credit markets: corruption and credit subsidy policy

We develop a model of vertical linkage between the formal and informal credit markets which highlights the presence of corruption in the distribution of formal credit. The existing moneylender, the bank official and the new moneylenders move sequentially and the existing moneylender acts as a Stackelberg leader and unilaterally decides on the informal interest rate. The analysis distinguishes between two different ways of designing a credit subsidy policy. If a credit subsidy policy is undertaken through an increase in the supply of institutional credit, it is likely to increase the competitiveness in the informal credit market and lower the informal sector interest rate under reasonable parametric restrictions. Any change in the formal sector interest rate has no effect. However, an anticorruption measure (increase in penalty) unambiguously lowers the interest rate in the informal credit market. Finally, we examine the effects of alternative policies on the incomes of different economic agents in our model.