September 7, 2011

Familiarity Breeds...Better Loans?

Everyone agrees: Discrimination based on race or religion is a bad thing in bank lending. But what about the reverse? A fascinating new study examines what happens when lenders grant more favorable terms to their own kind.

Topics: Management, India

“Discrimination” is — for good reason — a word filled with negative connotation, associated with such social ills as gender inequality in the workplace, racial profiling by police, religious persecution, and unequal treatment in everything from buying a car to securing a loan.

At the same time, preferring to do business with those of one’s own kind — whether gender, race or religion — sometimes happens with good reason. Often, it may be easier to assess the trustworthiness and reliability of those closer to you, and possibly also threaten retribution if they don’t conduct themselves honorably. Which is more important, the pernicious impact of favoritism or the efficiency-enhancing effects of better information and ‘social’ enforcement? It is a question for the data to decide.

In a study on Indian banking, Daniel Paravisini, an associate professor at Columbia Business School, finds that social proximity is actually good for loan outcomes — that is, increased efficiency outweighs favoritism. In “Social Proximity and Loan Outcomes: Evidence from an Indian Bank,” Paravisini and his coauthors, Raymond Fisman, a Chazen Senior Scholar and codirector of the Social Enterprise Program at Columbia Business School, and Vikrant Vig, an associate professor at the London Business School, assess whether loan officers lend more to those of their own religion and caste and whether religion and caste connections affect the probability of default.

Since bank personnel are rotated from branch to branch, some years borrowers will face a Hindu loan officer, and in others a Sikh or Muslim. By analyzing how lending behavior changes as a result, the researchers are able to tease out the effects of social ties on lending. Not only does lending go up when a loan officer of one's own group arrives to head the local bank branch, but these larger loans are also less likely to go into default in subsequent years. Paravisini and his coauthors argue that the decrease in default rates is likely the result of officers making more loans to those from their own caste or religion because the officers are better able to assess the likelihood of default by a member of their own group. They may also be able to apply social pressure to prevent default after a loan is made.

The research provides several policy-relevant insights into the role of social relationships in banking and other markets where it's hard to assess the reliability of trading partners. Most obviously, a bit of discrimination may not be a bad thing — it allows social connections to improve the quality of economic transactions. And the research also provides some rationale for affirmative action policies. If underprivileged minorities — such as the so-called “backwards classes” in India — are afforded the opportunity to become loan officers, they can help their entire community gain access to much-needed credit without exposing the bank to risky loans. Familiarity, after all, can breed good lending.

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