Greasing the wheels of bank lending: Evidence from private firms in China

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Abstract

Bribery, rather than firm performance, largely determines the extent to which private firms access bank credit in China. Bribery enables an economic outcome whereby firms with better economic performance are awarded larger loans. These firms also pay more in terms of bribes. Although satisfactory firm performance does determine whether firms can access loans, it does so only for loans originated by the big-four banks. For loans originated by smaller banks, performance is not essential for firms to secure loan access. Our evidence sheds light on the surprising finding of earlier studies that Chinese banks use commercial logic in their lending practices despite being endowed with a weak institutional framework.

Highlights

► Bribery largely determines if private firms have access to bank credit in China. ► Bribery enables firms with better performance are awarded larger loans. ► These firms also pay more in terms of bribes. ► Firm performance determines loan access only for loans from the big-four banks. ► For loans from smaller banks, performance is not essential for loan access.

Introduction

Chinese economic growth challenges the mainstream academic view of economic growth. In the literature on “law-finance-growth,” La Porta et al., 1998, La Porta et al., 2000 argue that the rule of law, private ownership and corporate governance are crucial elements in explaining economic success and corporate value, and Rajan and Zingales (1998) stress the need for highly developed capital markets and financial intermediaries to help foster a successful corporate sector. Despite recent improvements, China still has an underdeveloped and capricious legal system, weak investor protection and overarching government control/interference in the financial system. Following the argument put forward by the “law-finance-growth” literature, the Chinese economy and particularly its private sector should be subdued at best and completely irrelevant at worst. However, this is not what we observe. Allen et al. (2005) seek to explain the paradox by arguing that informal financing channels such as trade credits and private credit agencies may have helped private firms to grow.

Using Chinese government survey data from 2006, we examine formal financing channels, particularly the incentive mechanism that drives the allocation of bank financing for non-listed private Chinese firms. As bank lending accounts for 80% of financing for Chinese enterprises (Allen et al., 2005), it is arguably more important than other informal financing channels. Ayyagari et al. (2008) suggest that despite the weaknesses of China’s formal financial system, its financing is associated with faster firm growth, whereas fundraising from alternative channels is not. Further, Firth et al. (2009) find that Chinese banks extend loans to financially healthier and better-governed firms. Both of these studies conclude that Chinese banks exercise commercial judgment and are reasonably efficient in allocating credit to private firms.

China’s institutional background is not conducive to the efficient allocation of credit to private firms. A salient characteristic of the country’s banking sector is the dominant state ownership of banks, which in general reduces their governance and lending efficiency (Boycko et al., 1996). From time to time, macro-prudential policy imposes direct controls on both the total lending amount and which industries are lent to. Such government intervention adversely affects the efficiency of banks’ lending decisions. Moreover, China’s financial sector is beset by corruption. Kickbacks for loan approvals, massive theft by insiders, misuse of funds and large-scale fraud are routine in Chinese banks, brokerage houses, insurance companies and rural credit cooperatives. In a 2003 survey of 3561 bank employees, state-owned enterprises (SOEs), private firms, brokerage houses and rural households, 82% of respondents agreed that corruption was either pervasive or quite pervasive in financial institutions (Pei, 2008). How can we reconcile this institutional background with the empirical findings of Ayyagari et al. (2008) and Firth et al. (2009)? An analysis of credit allocation in the Chinese banking system could potentially address the question raised by Allen et al. (2005) of how China’s vibrant private sector can coexist with its weak legal system.

We argue that corruption acts as the proverbial grease for the bureaucratic wheels of an otherwise unmotivated banking system. We find evidence that Chinese credit is allocated in accordance with the entertainment and travel costs (ETCs) of private firms, a fudge item in company accounts. According to Cai et al. (2011), a significant portion of firms’ ETCs is used to build relational capital. Previous findings on the commercial judgment of Chinese banks appear to be driven largely by the ETCs of private firms; in other words, by how the bankers are entertained. Moreover, our empirical results seem to indicate that better-performing firms tend to spend more on ETCs. We thus argue that a benign equilibrium drives the efficiency of the Chinese financial system’s private firm financing. The better-performing Chinese firms can better afford to entertain the bankers, and the bankers in turn allocate more credit to these firms. China’s weak legal system allows for such an equilibrium to exist because, as Pei (2008) notes, the country rarely prosecutes corruption.

It is interesting that the bureaucratic procedure for loan making, instated in 1995, seems to be an integral part of this benign equilibrium. In particular, commercial banking law requires an internal credit assessment unit to crosscheck all lending decisions independently of the loan-making unit. This bureaucratic procedure imposes much-needed top-down discipline in a system plagued with corruption. In this study, we present evidence that bureaucratic rigidity is not uniformly enforced in the banking system and show that the procedure is intentionally slack in terms of checks and balances. We further show that smaller banks in poor provinces allow firms access to bank credit regardless of poor economic performance. These many exceptions notwithstanding, the legal establishment of commercial logic as a new conduct norm has had a significant influence on bank lending practices. Instead of total neglect, the bribery game now uses firm performance as its focal point. Better-performing firms are capable of more graft and are rewarded with more bank credit. Rather than neutralizing commercial logic, the grease-the-wheel mechanism reinforces it.

Our empirical results support the importance of the grease-the-wheel mechanism to Chinese banking practices. Although the internal control system imposes an important rigidity on bank lending, graft payments secure discretionary financing, and individual-banker incentives play an important role. The loan size decision is a particular case in point. Our empirical evidence shows that bribery, although not itself sufficient, is of more help than performance to firms attempting to obtain larger loans.

Different credit allocation mechanisms have different implications for the Chinese economy. When profitability is used as a screening device conceivably prescribed through the grease-the-wheel mechanism, credit is allocated to the most profitable projects. As a result, the most efficient firms incur higher bribery costs but obtain the credit needed to expand. In an imperfect market, when bankers directly charge firms with bribes instead of assessing their profitability, the banks may take on too much credit risk, resulting in a much less efficient economy. Likewise, when banks lend according to political connections, firms that are deeply imbedded within the system have advantages in accessing credit. These firms are usually SOEs or newly privatized SOEs that tend to be less efficient. In both cases, the growth of the most efficient firms in the Chinese economy, i.e., private firms, is affected by a lack of access to working capital and financing for fixed investments. These bad practices adversely affect both the profitability of China’s commercial banks and possibly the stability of the Chinese financial system.

Our results find that corruption plays a significant role in bank lending. This is consistent with the recent banking literature. Beck et al. (2006) find that stronger oversight powers are correlated with more corruption in bank lending. Barth et al. (2009) examine the effects of both borrower/lender competition and information sharing via credit bureaus/registries on corruption in bank lending. They find strong evidence that both banking competition and information sharing reduce lending corruption, and that the latter helps enhance the positive effect of the former. Houston et al. (2011) examine the effects of media ownership and concentration on bank lending corruption and find strong evidence that state ownership of media is associated with higher corruption levels. They also find that media concentration increases corruption both directly and indirectly through its interaction with media state ownership. Our results differ from these earlier works. Instead of finding ways to curtail lending corruption, we highlight corruption as being conducive to efficient lending in a second-best world.

In the context of developing countries’ weak legal frameworks, our results support an important argument in the corruption literature: that corruption plays a role in improving efficiency and aids in private firm growth. According to this argument, in a second-best world populated by pre-existing, policy-induced distortions, corruption represents the much-needed grease for the squeaking wheels of a rigid administration. As Beck and Maher (1986) and Lien (1986) point out, in a bribery game in which private firms bid competitively for government procurement contracts and corrupt officials award contracts to firms that offer the highest bribes, allocation efficiency is maintained because only the lowest-cost firms can afford the largest bribes. Our view contrasts with empirical works (Mauro, 1995, Kaufmann and Wei, 1999) that observe a significant negative relationship between corruption and investment that extends to growth. However, our evidence is consistent with that of Bardhan (1997), who recalls episodes in European and American history when corruption might have favored development by allowing entrepreneurs to grow out of bribery.

Section snippets

The Chinese banking industry

China’s banking sector is still predominantly owned by the state. Before the late 1990s, the Chinese banking sector mostly served as a conduit for channeling low-cost capital to SOEs, and the private sector was virtually excluded from the formal credit market. Policy lending was a defining characteristic of the banking system. As a consequence of this policy lending, banks in China were saddled with extensive portfolios of non-performing loans (NPLs). Western observers generally estimated the

Testable hypotheses and empirical testing strategies

The empirical evidence of reasonable efficiency in the Chinese banking system as reported by Ayyagari et al. (2008) and Firth et al. (2009) does not fit well with the system’s omnipresent bureaucratic red tape. Meanwhile, this institutional setup, together with the lack of enforcement of anti-corruption laws, implies fertile ground for corrupt practices. In this section, we pose several testable hypotheses and attempt to link these two observations.

In formulating our ideas, we borrow from the

Sample

The data used in this study come from a nationwide survey of privately owned enterprises that was jointly conducted in early 2006 by the All China Industry and Commerce Federation, the China Society of Private Economy at the Chinese Academy of Social Sciences and the United Front Work Department of the Central Committee of the Chinese Communist Party. It comprises mainly large firms and some small- and medium-sized enterprises, drawn from 31 provinces and covering all of the same-level

Empirical results

Table 1 contains the summary statistics for the full sample. Because bank lending behavior in developed and undeveloped areas may differ, we also differentiate our sample based on the GDP per capita of the provinces in 2004. We use the 2004 GDP per capita because macro-conditions are normally leading indicators of economic development, and this study uses survey data as of the end of 2005. The top nine provinces, i.e., Beijing, Tianjin, Liaoning, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong

Robustness check

Because both corruption and bank loan applications are decisions made by a firm, they can be endogenous. More specifically, bribery amounts affect a firm’s ability to get bank loans, further influencing its future performance, and the latter may yet determine its capacity for bribery. To address this possible endogeneity issue, we must find some ETC instruments that explain the bribery amount but have less of an effect on firm performance. For this purpose, we use the high school education dummy

Conclusions

We use a unique firm-level dataset to analyze whether the grease-the-wheel mechanism works in the Chinese banking industry. Studies have shown that Chinese banks use commercial principles and firm quality as major determinants in their lending practices. This finding is surprising because the Chinese economic system relies on unconventional governance methods such as corruption and political connections rather than a strong legal framework when allocating scarce economic resources (Pei, 2008,

Acknowledgements

Yunling Chen acknowledges financial support from the Minoru Kobayashi China Economic Research Fund. Jun Su acknowledges financial support from the National Natural Science Foundation of China (Approval Number 71102118), 2012 merit-based scientific and technological projects to returned scholars from overseas by Beijing Municipality and Accounting-based investor protection Research Base of Beijing Municipal commission of Education. We thank Mara Faccio, Colin Xu and an anonymous referee for

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