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related lending

Lending to Bank Insiders: Crony Capitalism or a Fast Track to Financial Development?

Bob Cull's picture

Bankers often extend credit to firms owned by their close business associates, members of their own families or clans, or businesses that they themselves own. On the one hand, this allows banks to overcome information asymmetries and creates mechanisms for bankers to monitor borrowers. But on the other hand, related lending makes it possible for insiders—bank directors—to expropriate value from outsiders, be they minority shareholders, depositors, or taxpayers (when there is under-funded deposit insurance). The evidence suggests that during an economic crisis insiders have strong incentives to loot the resources of the bank to rescue their other enterprises, thereby expropriating value from outsiders. In a crisis, loan repayment by unrelated parties worsens, and banks thus find it more difficult to reimburse depositors and continue operations. Consequently, insiders perform a bit of self-interested triage: they make loans to themselves, and then default on those loans in order to save their non-bank enterprises. Outsiders, of course, know that they may be expropriated, and therefore behave accordingly: they refrain from investing their wealth in banks, either as shareholders or depositors. The combination of tunneling by directors, the resulting instability of the banking system, and the reluctance of outsiders to entrust their wealth in banks results in a small banking system.

And yet, the economic histories of many developed countries (the United States, Germany, and Japan) indicate strongly that related lending had a positive effect on the development of banking systems. If related lending is pernicious, why then did it characterize the banking systems of advanced industrial countries during their periods of rapid growth? In fact, related lending is still widespread in those same countries.