Relationship banking, deregulation and short-term debt
Relationship banking, deregulation and short-term debt
In economies with limited mechanisms for designing and enforcing contracts, it is often important for individual banks and firms to establish stable relationships. Such ‘relationship banking’ can be used to overcome information asymmetries between borrowers and lenders, and make promises by either party credible, when explicit contracts fail to do this.
This paper attempts to use the idea of relationship banking to explain the build up of short-term foreign debt in East Asian economies in the period prior to the financial crisis of 1997-99. It presents a theoretical model, deriving conditions under which this pattern of debt could emerge from the rational decisions of firms and banks with incomplete contracts and asymmetric information. It then presents evidence from previous studies on the East Asian crisis which supports the model’s predictions, including that:
- financial crises were very low-probability events in East Asia because of high growth, making short-term foreign investment rational
- the demise of state coordination of banking made it profitable for good banks to signal their quality by demonstrating that they had the confidence to borrow from global financial markets
- after the period of liberalisation in the 1990s, there was a movement towads shorter-term borrowing by firms and banks
- large, efficient East Asian firms depended on short-term relationship loans from local banks, which in turn took the lead in short-term foreign borrowing
- it was these banks and firms that were hit hardest by the crisis
In conclusion the paper considers policy propositions for avoiding future crises. It argues against taxes on short-term foreign capital inflows, noting that these could deprive good banks of valuable signals and stifle efficient relationship-based investments. It suggests instead that, in countries with a tradition of productive relationship banking, such as those in East Asia, governments with sufficient reputation to get cheap long-term foreign debt should borrow abroad and co-ordinate noncontractible investments with appropriate subsidies.