Banking Relationships: Vital to the Economy

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.