The first article in the FT’s series on “Race and Finance” in the United States provides anecdotal evidence that banks can miss profit opportunities by lending to small businesses in minority neighborhoods (The Big Read, December 14) . I wish to offer a possible explanation for this.
Over the past decades, the US banking sector has seen a massive increase in concentration. Since 1984, the number of banks has declined by 70 percent. The consolidation has been accompanied by an attrition of local lenders, based in the neighborhood. It is understandable that a large institution uses analytics, which can be created and managed centrally, to assess credit risk. Lenders from these banks earn bonuses for granting loans that meet data-based standards. They are generally immune to loss, so it doesn’t make sense to give them the power to use non-quantifiable factors – which we recognize as judgment – to make loans.
However, as Friedrich Hayek, the Austro-British economist has pointed out, “particular knowledge of the circumstances” cannot be easily quantified. A good example of this is the courage of Adenah Bayoh, the entrepreneur featured in the article. A smaller local lender is more likely to take this quality into account. The reason is that senior management and major shareholders are closer to lending decisions because there are fewer loans and they know the area well.
Additionally, if a bank’s management discriminates against certain groups – either through error in judgment or through prejudice – it will create a profitable lending opportunity for a competing local bank.
A point to remember is to examine the reasons for the disappearance of local banks and to propose changes – in regulation and perhaps in other areas – that will allow them to operate profitably. A system that can provide small loans to small entrepreneurs not only helps borrowers, but also promotes more efficient allocation of resources in the economy.
Massachusetts Institute of Technology Cambridge, MA, United States