Banking: Why geography matters

By Felix Salmon
January 3, 2011
Jeff Grabmeier reports on some interesting research from Ohio State's Stephanie Moulton, which shows that borrowers with low incomes or bad credit are significantly less likely to default on their loans if they borrow from a local bank than if they borrow from a distant bank or mortgage company.

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Jeff Grabmeier reports on some interesting research from Ohio State’s Stephanie Moulton, which shows that borrowers with low incomes or bad credit are significantly less likely to default on their loans if they borrow from a local bank than if they borrow from a distant bank or mortgage company.

Moulton tells Grabmeier that “local banks seem to offer some protection to homebuyers, particularly those with low incomes who may be seen as risky borrowers”, and comes up with a few hypotheses as to why this might be:

Many mortgage brokers base their decisions on whether to offer a mortgage on one or more key numbers, such as a credit score. In other words, if your credit score is above a certain level, and you meet other criteria, the broker will offer the loan. The same may be true of large, non-local banks, Moulton said.

But local lenders may place more weight on other factors, such as how long you’ve been working for your current employer, and whether you make regular deposits in a savings account…

In addition, local bankers are more likely to have a continuing relationship with the borrower, through the checking and savings accounts held by the customer.

“If there’s a relationship, the borrower may feel more obligated to make their payments. And the banks may provide more education and information to the borrowers, equipping them to be better homeowners,” she said.

I think the relationship point here is absolutely key. With bank loans, the give-and-take is all very asymmetrical: the borrower gets a large sum of money up front, and then does nothing but send money back to the lender from then on in. The incentive to stop paying the money back is clear.

If the borrower has a personal relationship with the lender, however, things change — and not just because of formal education and information. Making mortgage or other loan payments is a painful chore, most of the time. But for some people it can be a happy, joyful thing: I’m buying my house! I’m getting out of debt! And it’s a lot easier to think that way if you have a human local banker who is helping you reach your goals.

When reading Grabmeier’s piece, I couldn’t help but be reminded of Maha Atal’s post about Andhra Pradesh. The problem in AP, she says, and in India generally, “is not profit or size; it’s geography”:

When Yunus first started making loans to the local poor, he was pushing back against an argument from banks that people in poverty weren’t credit-worthy, that they couldn’t understand the concept of credit and therefore couldn’t be expected to pay. There was something to that argument: credit is a learned thing, both a legal concept and a social one that emerged in the developed world over centuries, whose core component is the creation of a sense of obligation between two perfect strangers.

Dr. Yunus did not actually challenge this notion; rather he sought to get around it, by demonstrating that loans did not have to be made between perfect strangers. The essence of microlending as he devised it was not simply that the loans were small, or that the rates were friendly, or even that the group system created a culture of pressure to repay the lender. It was that the groups were self-formed, that the members already knew each other, and that the obligation to repay was constructed as an obligation to one’s peers. He did not teach them to be obligated to the creditor; he saw that they were obligated to one another…

In India, the community component of micro-lending has never been taken seriously. Both the MFIs and the SHGs rely on the national financial system, not on local capital, to get started. Neither is able to operate as a borrower-owned community bank. And so both structures take as an assumption that grouping borrowers together can lead them to feel obligated to a third party, even though that is precisely the opposite of what the Bangladesh success story showed. As the sector has expanded, the distance–physical and therefore social–between lender and borrower has expanded it with it, and it is that distance, not the size of the industry itself, that is the problem.

A loan from a friend, or someone we know, is always qualitatively different from a loan from a faceless corporation. If you’re a college-educated sophisticate moving fungible funds from one account to another, it’s easy to forget this, but come down to my local credit union on check day, when a lot of local residents receive their Social Security checks. All of them have the option of having the money paid automatically into their account, but there’s always a long line of people queuing up to deposit their check in person, with a human teller. And it stands to reason that, ceteris paribus, the people who do that are more likely to pay back one of our loans than someone hundreds of miles away who just gets a printed-out statement in the mail each month.

The spectrum from India’s poor to America’s rich is a continuous one, and U.S. subprime borrowers are somewhere in the middle when it comes to financial sophistication and trust in institutions. Similarly, successful subprime lenders tend to be pretty high-touch institutions, which take great pains to position themselves both geographically and in terms of marketing materials as close as possible to those they would lend to. The average payday lender is much more likely to know any given borrower’s name, when they walk in to the branch, than any banker — and that gives the payday lender an advantage when it comes to the borrower’s willingness to repay the loan.

The problem, of course, is that opening up local branches is a strategy which is expensive, hard to scale, and difficult to implement overnight. But it certainly helps explain why lending strategies enforced in a top-down manner from distant executives with spreadsheets can end up underperforming.

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