Insider lending and bank ownership: The case of Russia

We develop a model of insider lending in which a borrower can give incentives to a bank manager to misuse his right of control by extending a loan at favorable rates to the borrower at the expense of the equity value of the bank. The model explains why insider loans are often made to borrowing firms that are also large shareholders of the bank. Although in principal every borrower could bribe the bank manager for insider loans, large shareholders have the power to fire the bank manager and will use this power if the manager extends insider loans to others. Therefore, a bank manager has an incentive to favor large shareholders when engaging in insider lending. Using a World Bank survey of Russian enterprises, we provide support for our model. We find that Russian firms and banks engaged in insider lending on the basis of loan volume. To limit insider lending, we propose proper incentives for bank managers, such as high penalties or equity incentive schemes. (C) 2001 Academic Press.