STANFORD CENTER FOR INTERNATIONAL DEVELOPMENT Working Paper No . 275 All Bad , All of the Time ? Related Lending and Financial Development

Does related lending, the practice of bankers extending credit to their own enterprises, help financial development by allowing bankers to assess risk ex ante and monitor borrowers ex post, or does it hinder financial development by creating a mechanism for bankers to loot their own banks? Drawing on both cross-country regressions and case studies we argue that whether related lending is positive or pernicious depends on the institutional context in which it takes place. Our results indicate that when rule of law is strong, related lending is positive for financial development. Our results also suggest when there are strong institutions of corporate governance, related lending is positive for financial development. Finally, our results suggest that depositor monitoring is positively associated with financial development, but that it is perhaps too blunt an instrument to detect when related lending is being used in ways that benefit (or hurt) banks. Taken as a group, our results indicate that there is no single “best policy” regarding related lending. Whether or not policy makers should deter bankers from extending credit to themselves and their business associates crucially depends on institutional context.