Banks’ relationships with borrowers are more important economically than many people realize. Research suggests that lending relationships can make bank failures’ effects worse—but can also help buoy an economic recovery.
Economists have long said that lending relationships are important, but it’s been tough to measure that importance. University of Toronto’s Jon Cohen, Chicago Booth’s Kinda Hachem, and University of California at Irvine’s Gary Richardson sought to do so using data from the Great Depression. That period is ideal to study, the researchers say, as bank runs were widespread, appeared to hit indiscriminately, and in many places were allowed to unfold on their own, without immediate central-bank intervention. However, data from that era lack the granular detail that the present day affords.
The researchers overcame this problem and sussed out banking relationships by focusing on the interest banks charged borrowers during that period. Using insights from a theoretical model, they argue that banks with mostly new relationships would have charged variable rates for individual loans—but banks with ongoing relationships would have used “soft information . . . accumulated over time through repeated interactions with their clients” to smooth interest rates for some of those clients in order to retain and give them incentive to undertake less risky projects. By tracking balance sheet and income statement data throughout the 1920s, the researchers can infer which regions had strong, ongoing lending relationships on the eve of the Great Depression.
When large banks failed, people ended up at smaller banks, helping those banks support their ongoing lending relationships.
Cohen, Hachem, and Richardson estimate that small-bank failures explain roughly a third of the Great Depression’s economic contraction. When small banks failed, valuable soft information essentially died with those banks, and that hurt the economy more than if a failure had destroyed a new relationship.
But the researchers also say that banking relationships can help mitigate a crisis. When large banks failed, Cohen, Hachem, and Richardson argue, people ended up at smaller banks, giving those banks the deposits they needed to support their ongoing lending relationships. Factoring that in, the researchers find that the economic effect of small-bank failures shrinks from one-third to one-eighth of the Depression’s contraction. Large bank failures and the ensuing migration of deposits toward smaller relationship lenders kept the Great Depression from being even worse.
And although the Great Depression ruined many long-standing banking relationships, surviving banks that rebuilt their relationships were stronger and better able to weather later economic contractions. Comparing the performance of commercial banks across geographic areas, Cohen, Hachem, and Richardson find that areas where banks rebuilt “the types of continuing relationships that they embraced in the 1920s” fared better during the 1937–38 recession than areas where banks didn’t rebuild those long-term relationships.