Should You Know Your Banker?

Are open markets threatened more by a pro-business or by an antibusiness ideology?

The New York Times, "Economic Scene" , December 03, 2003

In the good old days, your local bankers knew you. You saw them in person, and maybe played golf with them or attended the same church. They didn't need a credit report to decide whether to give you a loan. Your character wasn't reduced to a numerical score. Trust didn't require computers or background checks.

If those good old days sound humane, consider what those lending practices mean to the outsider -- to the upstart who doesn't belong to the right country club, isn't from the right family, isn't of the right race -- or to the insider whose entrepreneurial idea threatens established businesses.

Financing based on reputation quickly turns into financing based on connections, a closed system where what matters isn't what you know but whom. That system pleases incumbent businesses, which can get the funds they need without worrying about pesky new competitors. Controlling finance is a way to control the whole economy.

In their recent book "Saving Capitalism From the Capitalists" (Crown Business), the economists Raghuram G. Rajan and Luigi Zingales, both of the University of Chicago's Graduate School of Business, argue that the biggest threat to open markets today, and their greatest rival, isn't an antibusiness ideology. It's the pro-business but anticompetitive system they call "relationship capitalism."

"Relationship capitalism is basically where a lot more is done through contacts -- who you know, how you know them -- rather than through arm's-length contracts, more transparency, more open dealing and so on," says Professor Rajan, who is now serving as the International Monetary Fund's chief economist. In relationship capitalism, "we do less through contracts and more through handshakes."

The system sometimes arises as the best way out of a bad situation. Personal relationships can replace an unreliable legal system in which formal institutions don't enforce contracts and the law doesn't require the information disclosure on which competitive finance depends. Extended families, close ethnic groups, or local social sets substitute reputation and social sanctions for courts and contracts. These arrangements are particularly common in developing countries.

But relying on reputation means keeping the group small. And keeping the group small conveniently limits competition. So relationship capitalism tends to survive when it's no longer needed, hampering economic growth.

Professors Rajan and Zingales argue that financial markets make the biggest difference between open, market capitalism and closed, relationship capitalism. Free financial markets allow outsiders with good ideas to raise funds, even when their businesses will compete with insiders.

"Free financial markets are the elixir that fuels the process of creative destruction, continuously rejuvenating the capitalist system," they write. "As such, they are also the primary target of the powerful interests that fear change."

In the United States, state laws used to limit banks to a single branch or, at the very least, to block out-of-state banks from doing business. As a result, many farmers could barely obtain financing, since small local banks were reluctant to risk their limited capital on unpredictable weather.

Farmers wound up paying exorbitant interest rates to the few lenders available and often sank hopelessly in debt -- giving financiers and markets a bad reputation.

Only in the last couple of decades has this closed system opened up. Technology allowed out-of-state banks to compete in places where they had no branches, and under pressure from that competition, states gradually lifted their restrictions.

"Rather than seeing their small, inefficient local champions being overwhelmed by outsiders, they withdrew the regulations limiting branches," the economists write. "With the exception of a few inefficient banks, studies show that everyone benefited. The withdrawal of these regulations typically led to a significant increase in the growth rate of per capita income in the state and a reduction in bank riskiness."

Closed financial systems live on in much of the world, stifling economic development, blocking upward mobility and giving markets a bad reputation. Natives of India and Italy, Professor Rajan and Professor Zingales note that the American economy is far more open, and in their view fairer, than many around the world.

"Generally in markets around the world, access is very limited," Professor Rajan explains. "When people complain about markets, they aren't really complaining about the principle that you and I cherish and see, but really about the way markets function in practice in their corner of the world."

From 1936 until well into the 1990's, for instance, Italy's major companies and the banks that financed them were entangled in a complex system of quasi-public, quasi-private ownership that made both hostile takeovers and large-scale start-up financing virtually impossible. The system provided government subsidies for inefficient companies and gave politicians a way to reward supporters.

"First the Fascists and then the Christian Democrats used finance as a clientele system," Professor Zingales says. "Control of the bank has always been a major source of control of the country." Only the external pressures of EuropeanUnion requirements got Italy to break up its closed corporate system.

India's big businesses similarly enjoyed access to government-controlled financing. They paid high interest rates but didn't mind because they got the money they needed and were protected from competition. But when India began to open its economy to foreign trade, the locals suddenly found themselves at a disadvantage, paying more for financing than their new competitors.

They started to push for financial reforms they would once have opposed. And, Professor Rajan says, once powerful incumbents "swing behind reform, reform moves so much more quickly." India reformed its stock market, improved corporate governance, instituted an electronic stock exchange and developed derivatives markets. Many new banks entered both the corporate and retail markets.

The challenge, Professor Rajan argues, is to "get the elite, the incumbents, to move from standing in front of the markets to moving behind them."