The default rate on loans to related parties was 77.4 percent, compared to 32.1 percent for unrelated parties, while recovery rates were $0.30 per dollar lower for related borrowers than unrelated ones.
In many countries, banks typically provide loans to so-called "related parties," that is, to shareholders of the lending bank, their family members, or the firms they control. In the past, some economists argued that related lending improves credit efficiency - bankers know more about related borrowers than unrelated ones and therefore can better assess risk and sidestep bad investment projects. This view is sometimes referred to as the "information view" on related lending. Past studies of long-term bank lending in Germany and keiretsu groups in Japan have supported this optimistic perspective
But, in countries with weak corporate governance, related lending may create more problems than it solves, according to a recent study by economists Rafael La Porta, Florencio Lopez-de-Silanes, and Guillermo Zamarripa. In Related Lending (NBER Working Paper No. 8848), the authors examine the extent and impact of related lending in the Mexican financial system. They assert that cozy connections between lenders and borrowers "may allow insiders to divert resources from depositors and/or minority shareholders to themselves." For instance, lenders have the incentive to divert funds to the companies they control, as long as their interest in the company exceeds their interest in the bank. In addition, deposit insurance may induce banks to assume inordinate risks and lend to the related parties on non-market terms, aware that the state will bear the costs. In sum, related lending may be very attractive to the borrower but may bankrupt the bank. La Porta, Lopez-de-Silanes, and Zamarripa refer to this pessimistic perspective of related lending as the "looting view".
In direct contrast to ownership structures in Germany and Japan uncovered in previous studies, the Mexican banks typically were controlled by non-financial firms rather than the other way around. The Mexican banking setup is similar not only to that of many developing countries, but also can be seen in the early stages of development in England, Japan, and the United States. Another important feature of banks in Mexico during the sample period is that related lending was largely unregulated and that banking supervision was lax.
For this study the researchers collected data for all banks in Mexico on the identity of each bank's top 300 borrowers by total loan size in 1995. For each bank, they then gathered information on the borrowing terms of a random sample of 90 loans from the top 300 loans outstanding at the end of 1995 and tracked their performance through December of 1999. (The random sample encompassed more than 1,500 loans.)
The authors find that related lending represented a large fraction of the banking business in Mexico in 1995 (20 percent of all loans outstanding as of year-end 1995 were made to related parties). Moreover, when the economy slipped into a recession and the value of the insiders' equity in the banks declined, the fraction of related lending almost doubled for the banks that subsequently went bankrupt and increased only slightly for the banks that survived the crisis.
The borrowing terms offered to related parties were substantially better than those available to unrelated ones, even after controlling for observable financial characteristics. For example, interest rates on related loans were 4 percentage points lower than on unrelated ones. Similarly, 84 percent of unrelated loans posted collateral assets, compared to only 53 percent of related loans.
Of course, these findings are still consistent with information-view proponents, who would argue that advantageous terms to related parties are justified by the low expected default rates and more efficient allocation of capital. However, La Porta, Lopez-de-Silanes, and Zamarripa find that related loans had much higher default rates and lower recovery rates than unrelated ones. The default rate on loans to related parties was 77.4 percent, compared to 32.1 percent for unrelated parties, while recovery rates were $0.30 per dollar lower for related borrowers than unrelated ones. Perhaps most interestingly, the worst-performing loans were those made to persons and companies closest to the controllers of banks. In fact, in most cases, a dollar lent to a related person or a related privately-held company turned out to be a dollar lost. On the other hand, related borrowers emerged from the crisis relatively unscathed - bank owners lost control over their banks but not their industrial assets.
La Porta, Lopez-de-Silanes, and Zamarripa conclude that all their principal findings are consistent with the "looting view" rather than the more halcyon "information view" of related lending. They suggest that the best way to reduce the fragility of financial systems might be by scaling back on related lending. Such an effort could be achieved "by explicit regulation of related lending as well as by enhanced reporting requirements, better investor protection..and closer supervision."
-- Carlos Lozada