Decentralization in Financial Institutions: Theory and Evidence from China*

Decentralization facilitates more efficient use of local information but also can lead to agency problems and commitment failures. This paper develops simple models of a twotier hierarchy (the center vs. the local) to study the optimal division of lending authority between central and local bank managers. Using a unique data set collected by the authors from a survey of rural financial institutions in China, we empirically assess the determinants of decentralization. We find that concerns over agency problems (collusion and government influence) and especially commitment failures (excessive refinancing) explain the recent trend toward centralization of lending authority. We conclude that the inability of financial systems to exploit local information in weak institutional environments may substantially limit the efficiency of financial intermediation despite financial market liberalization. JEL Codes: G2, D8, P3