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Related lending and banking development

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Abstract

Does related lending have positive or negative effects on the development of banking systems? We analyze a unique cross-country data set covering 74 countries from 1990 to 2007, and find that related lending, on average, does not have any effect on the growth of credit. We do find, however, that there are conditional relationships: related lending tends to retard the growth of banking systems when rule of law is weak, whereas it tends to promote the growth of banking systems when rule of law is strong. We also find that related lending appears to be associated with looting when banks are owned by non-financial firms, but that it does not do so when non-financial firms are owned by banks. Our results indicate that whether related lending is positive or pernicious depends critically on the institutional context in which it takes place; there is no single “best policy” regarding related lending. These findings are robust to alternative specifications, including IV regressions.

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Notes

  1. In a crisis, loan repayment by unrelated parties worsens, and thus it becomes more difficult to reimburse depositors and continue operating as a bank. The insiders therefore find it in their interest to make loans to themselves, and then default on those loans in order to save their non-bank enterprises.

  2. For recent examples in this journal of the effects of the institutional environment on the conduct of international business, see Chacar, Newburry, and Vissa (2010) and Kim, Kim, and Hoskisson (2010).

  3. Data for countries that were previously members of the Soviet Union are not available until 1990.

  4. See Barth et al. (2001) for a description of the database. The survey and data are available at http://go.worldbank.org/SNUSW978P0.

  5. The Barth et al. questions in Box 1 were asked in 1998–1999 and again in 2002, and thus we have two observations for our index of related lending for each country. We compute the index for each country using the 1998–1999 responses and assign that value to all observations prior to 2002. For observations after 2002, we use the responses to the 2002 survey. We then take the average of those two observations for each country (weighted by the number of pre- and post-2002 observations), which we use in the regressions. As a practical matter, there was not much variance in responses from the 1998–1999 survey to the 2002 survey. Thus our results are not sensitive to the weighting scheme.

  6. The KKZ data set and its description are available at http://www.worldbank.org/wbi/governance/data.html. See Haselmann et al. (2010) on the effects of alternative legal changes on bank lending in transition economies.

  7. The correlation between the 2004 data and those from other years runs from 0.91 to 0.98.

  8. One potential issue with the construction of Depositor Monitoring is the treatment of countries without explicit deposit insurance. We assume that the anticipated coverage is not zero and yet small for these countries, and set the value of Depositor Monitoring for those non-deposit insurance countries to the highest value from the countries with explicit insurance (i.e., the lowest coverage limit relative to GDP per capita). However, the implicit insurance can be quite large if government faces a credibility problem without a legally binding coverage limit. In a robustness check, we treat these countries as having the most generous coverage. Our central results turn out to be robust to the treatment of these countries.

  9. Our results are robust to the exclusion of initial private credit (and other macroeconomic controls). These results are not shown, to conserve space.

  10. For reference, the countries with scores closest to 5.46 are Malaysia (5.52) and Costa Rica (5.57).

  11. For reference, the countries with scores closest to 4.45 are Bolivia (4.45) and Honduras (4.39).

  12. John et al. (2000) advance a theory in which corporate boards can craft management contracts so as to promote first-best value-maximizing investment choices by the bank. The implication is that our results might be biased, because one would think that such strong institutions of corporate governance might be more prevalent in environments in which the rule of law is weak. It is not possible, unfortunately, to operationalize their theoretical framework cross-nationally. There are indices that capture the power of minority shareholders to police corporate boards (e.g., La Porta et al., 1998), but there are not comparable cross-national indices that capture the ability of boards to control management. We note, however, that this potential source of bias works against our hypothesis: if weak rule of law is mitigated by institutions that allow boards to control management, then our regressions are underestimating the effect of related lending on credit growth in weak rule of law environments.

  13. To be more specific, the coefficients for Model 3 imply that only for countries with related lending scores below 20 would the relationship between rule of law and private credit growth be negative. No country in the data set has a related lending score below 19. For the lone negative value, corresponding to the country with a related lending score of 19 (Thailand), we cannot reject the hypothesis that rule of law has no effect on private credit growth. For all those above 35 (62 of 74 countries) the model implies a positive, significant relationship between rule of law and private credit growth at the 5% error level.

  14. For interested readers, we tabulated the effects of related lending on private credit growth conditional on the 25th, 50th, and 75th percentile level of rule of law and the effects of rule of law conditional on the 25th, 50th, and 75th percentile level of related lending in Appendix A.

  15. The significant coefficient for depositor monitoring in Model 5 is, however, similar to Cull et al. (2005), who find that generous deposit insurance has a negative impact on long-run financial development. In parallel to the findings on the effects of related lending in this paper, those authors find that the negative effects of generous deposit insurance on financial development are mitigated, or even reversed, in countries with well-established rule of law.

  16. To conserve space in Table 3, we do not show all possible model permutations. For example, the co-insurance variable does not appear in the simple models on the left-hand side of the table that do not incorporate interaction terms, and Model 7 doesn’t include all possible interactions between rule of law, monitoring by depositors, and related lending (because it leaves out rule of law * depositor monitoring). We have, however, run models with all possible permutations of the interaction terms using the related lending, rule of law, depositor monitoring, and coinsurance variables (available from the authors). Our main results for related lending and the interaction between related lending and rule of law hold in all of those specifications.

  17. In fact, a banker who owns a downstream firm might be inclined to loot it to save his bank.

  18. We note that the stark differences in results for crisis and non-crisis countries for the firm ownership of banks variable are not evident for either the single or related party ownership variables.

  19. They also show that these measures of social cohesion pass over-identification tests for excludability in growth regressions.

  20. The measure of ethnic fractionalization used by Easterly et al. (2006) ranges from 0 to 1, with higher values indicating more fractionalization. In our sample, the mean value is 0.44 and the highest value is 0.93 for Uganda. The lowest values are for Japan (0.01) and Korea (0.002). One might interpret the positive coefficient for ethnic fractionalization as indicating that at low levels of related lending fractionalization has a positive effect on private credit growth. However, that coefficient can be explained in the context of the values for related lending in our sample and its size relative to the coefficient on the interaction term. At the lowest levels of related lending in our sample, fractionalization is positively associated with private credit growth, but the relationship is never significantly different from zero, and thus we cannot reject the hypothesis that there is no relationship between fractionalization and private credit growth for those countries. At higher levels of related lending the relationship is negative, and becomes significant for related lending values near 50. So, for about a quarter of the sample we find no significant relationship for fractionalization. For the remaining three-quarters we find a negative, significant relationship, as one would expect.

  21. Ethnic fractionalization is not a good instrument, because we have no strong prediction about the relationship between it and our index of the permissiveness of related lending. Indeed, the significant results in Models 1 and 2 of Table 4 derive from the fact that related lending is permitted in some highly fractionalized societies and in some homogeneous societies. The correlation between ethnic fractionalization and the related lending index is 0.15 and not significant at the p=0.10 level; that is, ethnic fragmentation would not be a strong instrument for related lending, even if it is exogenous.

  22. Those industrialized countries are Switzerland, France, Japan, Malta, the Netherlands, New Zealand, Singapore, and the United Kingdom.

  23. To make sure that rapid growth in credit in the run-up to the recent crisis is not driving our main findings, we also estimated models for the period 1990 to 2000 and 1990 to 2004. Our main findings for related lending and its interaction with rule of law also hold in those models.

  24. In addition, the correlation between the related lending index and the indicator of financial crisis turns out to be weak (−0.22), suggesting that look ahead bias is unlikely to be driving our key results.

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Acknowledgements

The views are those of the authors and not necessarily those of the World Bank or its affiliate institutions. Imai gratefully acknowledges financial support from Wesleyan University for a Mellon Faculty Career Development Mini Grant. We thank Varun Kshirsagar and Yeon Soo Kim for their excellent research assistance, and Thorsten Beck, Richard Grossman, Lewis Davis, Aldo Musacchio and two anonymous referees for valuable comments. An earlier version of this paper was presented at the Harvard Business School International Research Conference, the 3rd Annual Workshop in Macroeconomics in Liberal Arts Colleges, and the Centro de Investigacion y Docencia Economicas. All errors are our own.

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Correspondence to Robert Cull.

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Accepted by Lemma Senbet, Area Editor, 17 November 2010. This paper has been with the authors for two revisions.

Appendices

APPENDIX A

Effects of Related Lending Conditional on Rule of Law and Effects of Rule of Law Conditional on Related Lending

This table tabulates the effects of related lending on banking development (i.e., growth in the ratio of credit to the private sector relative to GDP) at varying levels of rule of law (Panel A) and the effects of rule of law at varying levels of related lending (Panel B), based on specification 3 of Table 3.

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figure c

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figure b

APPENDIX B

Index of Official Supervisory Powers

The questions that are used to calculate the index of official supervisory powers are:

illustration

figure a

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Cull, R., Haber, S. & Imai, M. Related lending and banking development. J Int Bus Stud 42, 406–426 (2011). https://doi.org/10.1057/jibs.2011.1

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