Banking and Economic Development

Insider Lending:  Banks, Personal Connections, and Economic Development in Industrial New England  (1994) had its origins in an accidental discovery. I was researching the decline of New England’s regional economy and had hypothesized that constraints in the capital markets had led to an overconcentration of production in a small number of key industries, most notably textiles and shoes. I was teaching at Brown University at the time and decided to begin my research by looking at some bank records from the early nineteenth century that had been deposited nearby at the Rhode Island Historical Society. To my great surprise, I discovered that the banks lent the lion’s share of their resources to their own officers and directors and to people closely associated with those men. This finding piqued my curiosity, and I redirected my research so I could examine how a banking system based on insider lending might work. Today we associate such lending behavior with the crony capitalism that afflicts poor countries around the world. Yet New England’s economy experienced rapid and successful economic development. What accounts for the difference?

I worked out the basic explanation in “Banks, Kinship, and Economic Development:  The New England Case,” published in the Journal of Economic History in 1986, and then elaborated it for the book. In developing economies like that of early nineteenth-century New England, where capital was scarce and information highly imperfect and asymmetric, controlling a bank was a way to get access to credit. Such insider lending was not necessarily nefarious because bankers knew a lot more about their own creditworthiness (and that of the people with whom they were closely connected) than they did about strangers. Of course, there was always the possibility that bankers would be overconfident, channel too large a proportion of their funds to their own ventures, and endanger their own institutions as well as the financial system. However, bankers mitigated this risk in two ways. First, they organized the process of approving loans to give insiders with a stake in the bank’s survival—in preserving the goose that laid golden eggs—the ability to veto each other’s loans under cover of secrecy. Second, the high ratio of capital to total liabilities that characterized these early banks meant that excessive lending to insiders might hurt shareholders but would rarely cause a bank to fail. Even with these two safeguards, however, insider lending could have had a pernicious effect on the economy if bankers had monopoly power (as in Mexico under the Porfiriato) and could prevent rivals from forming their own banks. Another feature that helped make the practice work, therefore, was that entry into banking was essentially free in New England by the second quarter of the nineteenth century, so up-and-coming entrepreneurs who wanted to raise funds for their own ventures could organize banks. (On this point, see also my article with Christopher Galisek, “Vehicles of Privilege or Mobility?  Banks in Providence, Rhode Island, during the Age of Jackson,” published in the Business History Review in 1991).  It was this open access to banking that differentiated insider lending in New England from crony capitalism around the world, then and now. Indeed, in a developing economy, insider lending combined with open access could be growth enhancing. The thinness of markets made investors hesitant to put their money into single ventures, such as manufacturing companies. However, they eagerly bought bank stock. For them banks functioned essentially like investment clubs, enabling them to buy what were effectively shares in the diversified portfolios of the region’s most promising entrepreneurs.

The first half of Insider Lending develops this argument. The second half goes on to explore how the banking system changed as the economy developed and credit became more abundant. Once bank directors no longer needed their institution’s resources for their own enterprises, they had to learn how to profit from lending its funds at arm’s length. The difficulties they faced in obtaining information about the creditworthiness of borrowers led them to concentrate on providing short-term loans for commercial purposes and to forsake the important role they had hitherto played in financing economic development. At the same time, new difficulties they faced in conveying information to depositors about their own soundness encouraged them to spread the gospel of professionalization to competing institutions that were still conducting business in the old way. As a result, I argue, in the decades before the Great Depression conservative bankers’ fear of runs did more to promote prudential regulatory practices than did government reformers.

Related publications:

Naomi R. Lamoreaux, Insider Lending: Banks, Personal Connections, and Economic Development in Industrial New England (New York: Cambridge University Press, 1994).

Robert Cull, Lance E. Davis, Naomi R. Lamoreaux, and Jean-Laurent Rosenthal, “Historical Financing of Small- and Medium-Size Enterprises,” Journal of Banking and Finance 30 (Nov. 2006): 3017-42.

Naomi R. Lamoreaux and Christopher Glaisek, “Vehicles of Privilege or Mobility? Banks in Providence, Rhode Island, during the Age of Jackson,” Business History Review 65 (Autumn 1991): 502-27.

Naomi R. Lamoreaux, “Bank Mergers in Late Nineteenth-Century New England: The Contingent Nature of Structural Change,” Journal of Economic History 51 (September 1991): 537-57.

Naomi R. Lamoreaux, “‘No Arbitrary Discretion’: Specialisation in Short-Term Commercial Lending by Banks in Late Nineteenth-Century New England,” Business History 33 (July 1991): 93-118.

Naomi R. Lamoreaux, “Information Problems and Banks’ Specialization in Short-Term Commercial Lending: New England in the Nineteenth Century,” in Inside the Business Enterprise: Historical Perspectives on the Use of Information, ed. Peter Temin (Chicago: University of Chicago Press, 1991), 161-95.

Naomi R. Lamoreaux, “Banks, Kinship, and Economic Development: The New England Case,” Journal of Economic History 46 (Sept. 1986): 647-67.