Academic journal article Economic Inquiry

Collusion and Overlending

Academic journal article Economic Inquiry

Collusion and Overlending

Article excerpt

I. INTRODUCTION

   For a long time have Korean companies been engaged in unbridled
   expansionism financed through loans, inefficient octopus style
   management, and over and duplicate investment, thus expediting the
   structural failure of the economy. This failure to concentrate on
   profits, consolidation and efficiency provided the fuse to the
   bankruptcy bombs that triggered the foreign exchange and economic
   crises.... The collusion between the conglomerates, financial
   sector and politicians made this financial monopoly possible.
    (Chosun Ilbo, December 26, 1997)

Collusion and overlending in the Korean financial sector may be best illustrated by the above editorial highlight of Chosun Ilbo, the most read newspaper in Korea. Its 1997 financial crisis is primarily triggered by continual bankruptcies of chaebols (conglomerates), which, with assistance from politicians, had borrowed heavily from financial institutions in financing their investment projects. (1) Unlike some other Asian countries experiencing problems in their financial sector due to shifts in investment projects toward real estates (such as Japan, Hong Kong, and Thailand), chaebols in Korea concentrated mostly on manufacturing activities. (2)

In this study, we establish a tractable model of overlending with three key players, namely, chaebols, financial institutions, and politicians, as highlighted in Chosun Ilbo. The model is designed to achieve two primary goals that are crucial for matching some key observations during the Korean turmoil. First, we illustrate how overlending can be an equilibrium outcome with collusion between chaebols and politicians when the economic environment is favorable. This occurs despite that such a collusion distorts normal borrowing-lending operation by causing a discernible shift in loan composition from more to less-productive investment projects. Second, we show that, as the economic environment gradually deteriorates, there can be a shift from a collusion to a no-collusion equilibrium. The combination of deterioration in fundamentals and expectations of an equilibrium shift can trigger economy-wide financial crisis.

More specifically, we construct a simple principal-supervisor-agent model of corruption and overlending. The principal is the formal authority of loan decision making of a financial institution (or, in short, the financial institution). The supervisor is a politician who serves as the informational intermediary in the borrowing-lending arrangement via his/her connections and networking. (3) The agent is a chaebol of an unknown type, which seeks for external financing of a set of risky projects. A politician's favorable signal about the borrowing chaebol's overall performance would grant the approval of the loan to finance an array of risky projects whose returns depend on idiosyncratic shocks that cannot be washed out in aggregation within the chaebol. As an outside alternative to making the loan, the financial institution can invest in the world capital market where a fixed rate of return is guaranteed. This portfolio decision depends on a comparison of the expected average returns on the given set of risky projects with the safe returns on investments in the world capital market. While both the chaebol's type and the state of nature are unobservable to the financial institution, we, for simplicity, assume that politician's connections and networking can fully uncover the true type of the chaebol. This valuable information possessed by the politician is one that the financial institution has an incentive to purchase, but a low-type chaebol has an incentive to conceal. Whether the politician ends up revealing truthfully this information depends on how much to obtain from the lender in terms of general support versus how much to gain from the borrower in terms of bribes or side payments. When a low-type chaebol has the politician on its side, information is distorted and a collusion equilibrium arises. …

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