Rent Seeking in Elite Networks

Some more fascinating results in the ‘whodda thunk?’ category. You can track down the paper in various published and pre-published forms here. Note, while I’ve not changed any meanings, I’ve occasionally shortened a sentence without horsing around too much with [square brackets]. Otherwise elisions are marked with an ellipsis …

There’s growing recognition of the importance of social capital in improving economic outcomes. Social proximity can mitigate informational frictions, thereby enabling transactions otherwise inhibited by adverse selection and moral hazard problems. However, there’s also a dark-side exemplified in Adam Smith’s line “people of the same trade seldom meet” and echoed by Olson who identifies the emergence of self-serving interest groups created to further their own interests largely at the expense of others. Olson argues that, after a period of stable growth, countries have a tendency to accumulate rent-extracting institutions that ultimately lead to the decline of nations. 1

In this paper, we examine the role of elite social networks. … We obtain membership information of an important service club organization in Germany. … The objective of this network is to maintain its reputation as an elite network. … From the outset, it should be noted that our analysis focuses on firms whose CEOs are members of the same service club organization, which alleviates selection concerns to some extent. To quantify the effect of social connections on lending, our empirical strategy compares for the same firm, quarter by quarter, the financing provided by banks whose banker is a member of the same club branch as the firm’s CEO (in-group banks) to that provided by other banks (out-group banks). …

We exploit two events that generate perturbation in social connectedness between firms and banks: (i) entry of members to a club branch and (ii) the formation of a new club branch within a city. … We find that firms experience an increase in lending from the in-group banks that is 37.20 percentage points higher than from out-group banks after they enter a club branch and a 56.67 percentage point higher increase from their in-group bank after participating in a new club branch formation. Additionally, the probability of establishing a new relationship with the in-group bank relative to an out-group bank increases by 14.95 percentage points after joining an existing club branch and by 10.47 percentage points after participating in a new club branch formation. …

We find that the share of borrowing from in-group banks increases by 11.50–12.87 percentage points after firms join an existing or a newly established club branch. The increase in lending from in-group banks does not just constitute a substitution from out-group banks; we find that total borrowing increases by 13.89 percentage points after firms join an existing club branch and by 22.41 percentage points after firms participate in new club formation. Similarly, firm leverage significantly increases after these events by about 6– 9 percentage points. …

To differentiate between a rent-seeking mechanism and positive effects of connections on credit allocation, we evaluate the relative profitability of connected lending by comparing the return on loans (ROL) that banks generate from in-group vis-à-vis out-group transactions. Since we are able to measure ex post loan performance after interest payments, defaults, and recovery rates, all contract features that affect the banks’ returns, for example, differences in collateral, are accounted for.

We find that a given bank generates a 4.37 percentage point lower ROL on in-group loans compared to loans extended to out-group firms in the same city. Comparing lending from in-group and out-group banks to the same firm, we observe a 2.73 percentage point lower ROL for in-group banks.4 Investigating the drivers of the difference in ROL, we observe that while interest rates and recovery rates are not significantly different for loans made by in-group and out-group banks,5 in-group banks continue to lend to ailing firms after out-group banks start to withdraw lending. It is this excess continuation of firms as a going concern that stems from the soft budget constraint problem of in-group banks (Kornai 1986) that generates a lower ROL. This excess continuation constitutes a more disguised, harder to detect, form of preferential treatment, compared with changes in the price of credit.

To sharpen our analysis on the underlying mechanism, we exploit crosssectional differences in bankers’ incentives. An implication of Becker’s (1957) work on discrimination is that competition provides a means to mitigate taste-based discrimination if such practices are costly to firms. In competitive markets, firms (or in our context banks) that engage in costly discrimination face the risk of being driven out of business. Consistent with this view, we observe that banks engage significantly less in ingroup lending in areas where credit market competition is higher, and we find that the wedge between in-group and out-group ROL is smaller in areas with competitive banking markets.

Furthermore, we examine how career concerns affect rent-seeking behavior of bankers. A large literature argues that career concerns are an important mechanism in aligning agents’ incentives and preventing moral hazard. While younger bankers are subject to strong career concerns (bad performance may have a significant impact on future promotion and compensation decisions), older bankers, close to retirement, are less concerned about the impact of bad performance on future income. When we compare differences between in-group and out-group lending for young and older bankers in private banks, we find that young bankers engage relatively less in preferential in-group lending and the wedge between in-group and out-group loans is significantly smaller for young bankers. Overall, the cross-sectional results provide compelling evidence that bankers who bear higher costs of engaging in unprofitable activities participate less actively in connected lending. Looking at the wedge between returns on ingroup and out-group loans controls for differences in the ability of bankers with different degrees of incentives to generate different returns on lending in general. …

The paper closest to ours is Guiso and Zingales (2014), which analyzes connected lending in Italy in a setting very similar to ours. They uncover some similar patterns. Specifically, they find that banks allocate more credit to socially connected firms. The authors interpret this as evidence of social connections reducing borrowing constraints. However, since they do not have data on contract terms, the evidence on the underlying mechanism cannot be conclusive. …

Finally, our paper contributes to the understanding of differences between state and private bank financing. Governments around the world are taking ownership of large parts of the banking system, and this public-sector involvement in the banking sector might potentially have considerable longterm effects on many countries.

  1. In a similar vein, Acemoglu and Robinson (2012) warn us about the role of colluding elites in establishing extractive institutions as a major impediment to economic prosperity.
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2 Responses to Rent Seeking in Elite Networks

  1. paul frijters says:

    interesting and of course I am very sympathetic to this kind of research, which is tough and time-consuming to do.

    It will remain difficult to discount some alternative stories about this apparent favouritism of elder bankers to local businesses they know from the local club. For one, both sides are private organisation whilst rent-seeking usually has a loss to the general public. More importantly, perhaps one should see these soft loans as investments on the side of the bank in longer-run relations. This is a feature of German banking, much less known in the US: banks provide a lot of the loans provided in the US by investment firms, and the relations are long-term. There is of course also the issue of risks, which might be lower with local knowledge, leading to a risk-return tradeoff. Indeed, lending from unknowns is a signal of desperation, so the risk premium story is quite possible and hard to discount, however much they ‘control’ for observed defaults and such.

    The details of the technical analysis will also be very important here. Because these are long-term relations, many will be ongoing, raising the issue of what to do with loans that are outstanding or that lead to rolled-over loans, or additional investment. The decisions the authors made on that might be important.

    So interesting, but one really would have to crawl into the entrails of this paper to gauge its value. That will make it easy for German industry and policy to ignore. They’ll be discussing this paper at length in the German newspapers though!

  2. Nicholas Gruen says:

    Thanks Paul

    Always such a spoilsport bringing technical and broad cultural knowledge.

    These things are just not tweetable so will go nowhere of course.

    We’re after impact with our posting here at Troppo. We don’t want it weighed down with all this pointy headed stuff.

    As Karl Marx would have said if he’d had a better sense of humour “Egg-heads of the world unite, you have nothing to lose but your yolks.”

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