Abstract
There is a broad consensus that bankers in LDCs engage in related (insider) lending. There is not, however, a consensus as to whether related lending has a positive or negative effect on economic growth. We argue that related lending has negative consequences for growth compared to the outcome that would obtain in an efficient capital market because bankers choose borrowers based on personal contacts rather than the quality of the underlying projects. The result is the misallocation of capital. We also argue that related lending arises as a rational response to high levels of default risk. Thus, it is an endogenous outcome of weak property rights and/or information asymmetries that are costly to overcome. In sum, related lending is a second-best outcome, but it is superior to the readily available alternative: banking systems that effectively do not lend at all for productive purposes.
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