# **III. Characterizing the Data**

## **_A. Are IRCs Binding?_**

The presence of IRCs is a necessary yet not sufficient condition for legal restrictions to be binding, that is, to lead to out of equilibrium interest rates. The mainly legal aspects of IRCs presented in the previous section are important per se, being particularly useful for policy makers, researchers and market participants interested in comparing specific features of a country’s IRC regime with those in other countries. However, the economics of IRCs are equally important. In this context, it is of special interest attempting to assess whether IRCs are binding. This happens when caps (floors) on lending rates are below (above) the market rates, that is interest rates based on the market forces of demand and supply, and when caps (floors) on deposit rates are set at a level below (above) market rates. In these circumstances, regardless of the intended objectives, IRCs can have nontrivial consequences for savings and investment and, ultimately, for welfare, as discussed in section I.

Assessing the bindingness of IRCs is not an easy task. There is no well-established methodology to judge whether the prevailing level and structure of interest rates is out of equilibrium. For one, when IRCs are in place we may not be able to observe market rates directly. Actual rates are not an accurate indicator of market rates where IRCs are in fact binding, since the actual rates reflect the influence of the cap or of the floor. The multiplicity of IRCs is another complication. As shown in the previous section, often countries set different caps or floors for different banking products, providing rational financial institutions with room for regulatory arbitrage so that they can borrow where they can pay below market rates and lend where they can obtain market rates. In principle, one would expect that under competitive conditions the expected real interest rates on savings instruments is positive, else there would be a strong tendency to substitute hoarding of cash, goods and self-investment for financial savings. Yet occasionally, in the presence of volatile inflation, real interest rates in an economy can be negative even when rates are free and competitively determined.<sup>14</sup> Finally, international comparisons with similar countries and markets may provide useful indications on interest rate levels, yet differences in regulations and other country characteristics may be difficult to isolate.

We measure the bindingness of IRCs that apply to commercial banks by taking the difference between the legal limits and the actual interest rates. The gap, expressed in percentage points and in real terms, between the _de jure_ limit, as reported by the country authorities in our survey, and the observed actual average interest rate charged or paid by commercial banks in a country provides a preliminary indication of the degree of bindingness of IRCs and therefore of interest rate repression.<sup>15</sup> The lower the gap between the regulatory limit and the interest rate for caps on deposit and lending rates, the higher the degree of bindingness of IRCs. A gap of zero may indicate full bindingness. For floors on deposit rates, the higher the gap between the interest rate paid by lenders and the regulatory minimum, the more binding is the IRC. Where multiple legal limits exist, we calculate our gap measure for the most representative product-level IRC that apply to commercial banks in a country. For example, Colombia reported legal (usury)

> 14 A similar argument can be made in the context of very low policy rates and unconventional monetary policy. 15 While most of the countries provided accurate references to the level at which floors and ceilings were set, their responses in terms of actual market rates were much more limited. As a complement to the survey, we therefore collected market rate information from the IMF’s International Financial Statistics and central banks’ webpages.

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