The Institutional Foundations of Lending: Indirect Regulation and State-Building
makes two main theoretical contributions to the scholarship on credit markets and institutional development. First, the book demonstrates that opportunistic lenders can take advantage of borrowers by collecting collateral over which they have no legitimate claim, and that one of the most fundamental ways institutions support lending markets is to minimize this risk to borrowers. Second, the book shows that states across time and space have used a similar strategy to mitigate risks to borrowers and lenders at relatively low cost to themselves.
I propose a theory of indirect regulation, an institutional arrangement that has balanced the coercive capacity of borrowers, lenders, and states in a variety of cases, including those in which states were relatively impecunious, weak, and corrupt. By preventing lenders from pursuing privately, or by co-opting groups that are unable to pursue privately, a state can provide ex post protection for borrowers. As long as borrowers can reliably identify members of this constrained group of lenders, then they can choose them as partners in an effort to minimize the risk of theft, extortion, and abuse. Members of the constrained group not only have a common interest in protecting their good reputation in the interests of competitive advantage, but can also protect themselves by sharing information about clients. Borrowers, in turn, have incentives to repay to maintain access to this source of non-abusive capital. The key element of this model is the state’s provision of formal institutions to group members. By offering state-backed adjudication and collection to lenders who cannot collect on their own—contingent on tax payment and in-group regulation—the state can ensure that these lenders will not circumvent the frameworks it provides. Borrowers, for their part, can be confident that they will not be pursued privately or for illicit claims, while knowing that they will be pursued after genuine cases of default. Ironically, formal credit sectors were, largely, built on the systematic disempowerment of lenders by the state, rather than on the efforts of powerful individuals to protect their capital.
I explore the implications of my theory across two sets of cases that allow me to compare variation in state capacity, institutional organization, and credit market outcomes. In the first set, medieval England and colonial Uganda, relatively weak colonial states provided institutional privileges to an ethnic minority group in exchange for high tax payments. In both cases the state was initially composed of a tiny group of foreign colonizers who had to consolidate their power over a hostile indigenous population that differed from them in language and custom. Both states were forced to strike a delicate fiscal balance: inadequate revenue would undermine state power, but heavy extractions could invite rebellion. Each responded by building an indirectly regulated institutional system that took advantage of tensions between ethnic groups. At a time when neither state could have comprehensively regulated strong and wealthy elite lenders, both created partnerships with vulnerable and highly-identifiable racial and ethnic minorities and gave them exclusive access to high-quality contract enforcement. Yet both systems were also fatally undermined by pressure from the indigenous population, as each set of rulers was forced to expand access to these small, high-quality frameworks. Unable to manage this new demand, the institutions that had once provided excellent adjudication to a small minority were overwhelmed.
The second set of cases—the United Kingdom and United States in the early twentieth century and Uganda at the beginning of the twenty-first—allows me to explore indirect regulation in a more modern context. In the nineteenth century the bulk of the English courts were of questionable quality, and disputes were adjudicated by untrained and highly corrupt judges. In a sweeping series of reforms, the government used licenses and registration to construct groups of regulated retail lenders who paid taxes in exchange for the right to enforce their contracts in the courts of the state. Contracts made by illegal lenders, or which contained illegal provisions, were ineligible for adjudication or enforcement. The United States, facing similar problems, undertook a comparable set of reforms. Both countries were, in less than half a century, able to bring chaotic credit markets to heel by building an institutional system that allowed reputable lenders to identify themselves and operate legally while submitting to both taxation and regulation.
Uganda, in contrast, remains mired in institutional inadequacy. Despite concerted efforts at reform, the country’s judicial system is slow, corrupt, and routinely circumvented; the country’s credit markets remain relatively shallow even after a quarter century of peace, economic growth, and state commitment to free market competition. Worse still, institutional reforms have not incorporated protections for borrowers, and small-scale lending has suffered a crisis of confidence in the face of widespread abuses. Rather than being a short-cut to developed credit markets, incomplete institutional grafts from the developed world may further undermine the country’s institutions.
The lessons of these cases are general. The institutions that underpin credit markets must provide protections for both borrowers and lenders. Successful institutional frameworks are, however, costly and complex. States that have relatively few resources, and which cannot reliably control powerful domestic actors, are unlikely to be able to create such institutional systems from nothing. Piecemeal efforts to build or reform institutions may, in fact, undermine them.