LSE research shows banks influenced to lend to governments

A feeling of trust in a country’s population is a vital component in a bank’s decision to lend to a government, according to a new study from the London School of Economics and Political Science and the University of California, Berkeley.

Building on previous research into the propensity of investors to favour individuals and institutions with culturally similar backgrounds when choosing their investments, this study provides the first evidence of the influence of cultural stereotypes in bank lending to governments.

The research also sheds light for the first time on how such cultural stereotypes are passed on to decision-makers in bank headquarters through multinational branch networks.

Using Eurobarometer data to measure bilateral trust between European populations, and recording the locations of bank headquarters and their branches across the European regions, researchers found that banks’ sovereign debt exposures were strongly affected by the levels of trust expressed in the countries in which the banks operated. The study also developed an innovative empirical framework to isolate the effect of trust as opposed to unobservable factors that might be influencing sovereign exposures across countries and time.

The study was conducted by Orkun Saka at the London School of Economics and Political Science (LSE) and Barry Eichengreen of the University of California, Berkeley. It has been published by the LSE Systemic Risk Centre.

Commenting on the findings, Barry Eichengreen said: “Our findings have implications for financial allocations. These trust-induced changes in portfolio allocations have nothing to do with the fundamental risk of the target country and simply reflect cultural stereotypes. For this reason, they are likely to distort banks’ portfolio decisions and reduce their profitability.”

Orkun Saka said: “Our results should invite multilateral banks to rethink the diversity of managerial teams responsible for cross-country investments. Banks with branch networks that are geographically well diversified and whose management teams similarly are geographically well diversified are less likely to fall into the trap of relying on cultural stereotypes. Diversity in bank management brings in a more balanced view of the potential investments and consequently more efficient portfolio allocation.”