What Can Commercial Banking Learn From Investment Banking?

Banking is the foundation of modern economies, facilitating the flow of funds from savers to borrowers, supporting commerce, and driving industrial growth. Despite its regulated nature, banking across the globe has been marred by recurring irregularities -- ranging from fraud, related party lending, misallocation of credit, and rising non-performing assets.

A concept often implicated in such irregularities is relationship banking, where long-term personal or institutional ties influence banking decisions more than purely objective financial criteria.

Relationship banking, in its ideal form, builds trust, supports credit to small borrowers, and promotes financial inclusion. Yet, critics argue that when stretched too far, it degenerates into favouritism, cronyism, and political interference, becoming a root cause of banking irregularities.

Interestingly, this problem is largely confined to commercial or retail banking, while in investment banking; such practices are structurally infeasible due to the reliance on markets, disclosures, and institutional oversight.

Relationship banking refers to the practice of banks building long-term, trust-based ties with clients, often extending services or credit on the basis of familiarity, loyalty, and personal confidence rather than purely on impersonal risk assessments.

A small trader may secure a loan without collateral because the branch manager has known the trader for years, or a large corporation with established ties may negotiate favorable loan terms, restructuring or relaxed repayment schedules.

While such practices reduce information asymmetry and support long-term partnerships, they also open avenues for subjective discretion. When left unchecked, this discretion undermines prudential banking norms and fosters irregularities.

The most significant way in which relationship banking fosters irregularities is through cronyism and favoritism. Lending is often extended to influential individuals or entities not on the basis of creditworthiness but because of personal or political connections.

State-owned banks in many countries have accumulated massive non-performing assets due to loans granted to politically connected conglomerates.

The case of Indian banks in the 2010s illustrates this clearly, when politically powerful business houses received massive loans with little scrutiny, later defaulting and causing banking stress. Beyond favoritism, relationship banking weakens risk assessment. Personal trust often overrides objective evaluation, with bank officers bypassing credit appraisal procedures because they ‘know’ the borrower. Collateral is undervalued, repayment ability ignored, and future cash flows exaggerated. Over time, such compromises create hidden risks that later surface as defaults.

Conflicts of interest also emerge under relationship banking. Managers may grant loans to friends, relatives, or political allies even when such loans are against the bank’s interest. Cooperative banks in many countries have collapsed precisely because of close community ties that encouraged lending without safeguards.

Similarly, regulatory arbitrage flourishes when relationships dominate.

Borrowers with political clout may use their ties to pressure regulators to turn a blind eye. The East Asian financial crisis of 1997 highlighted this when banks in countries such as South Korea and Thailand extended reckless credit to large conglomerates, ignoring risks until collapse.

Relationship banking also fosters a culture of moral hazard. Borrowers with strong political or institutional ties often assume that banks will restructure loans, extend fresh credit, or even secure bailouts. This reduces incentives for prudent behavior and embeds irregularities into the system. 

The impacts of such practices are far-reaching. Citizens lose faith in the fairness of the financial system when loans are granted on personal connections rather than merit.

Credit is misallocated to unproductive but well-connected borrowers while innovative entrepreneurs are denied access to funds. Systemic risks accumulate as banks overexpose themselves to a handful of powerful business groups.

Over time, this creates vulnerabilities that destabilize entire financial systems, while scandals and frauds proliferate.

It is important, however, to recognize that such irregularities are almost entirely confined to commercial and retail banking, while investment banking operates under a different structure where these abuses are not possible.

Investment banking deals primarily with underwriting securities, managing mergers and acquisitions, and raising capital through public offerings. These activities are highly transparent, market-driven, and governed by stock exchanges and securities regulators.

Personal relationships have far less room to influence outcomes. Unlike retail or small business borrowers, the clients of investment banks are largely institutional investors, corporations, and governments.

These clients demand rigorous due diligence, independent valuation, and strict compliance. Lending or underwriting decisions cannot rest on personal ties but must withstand scrutiny from boards, regulators, and markets.

Moreover, investment banking operates under securities laws that mandate full disclosure of risks, audited financials, and third-party assessments. For instance, an Initial Public Offering cannot be approved based merely on the relationship between an entrepreneur and an investment banker; it must be vetted by regulators. Reputation also acts as a powerful safeguard in investment banking.

Investment banks thrive on credibility, and any hint of favoritism or manipulation in underwriting, advisory, or trading severely damages their standing in global markets. Hence, reliance on objective standards is not only a regulatory necessity but also a commercial imperative.

Unlike state-owned commercial banks, investment banks are also relatively free from political interference, since their transactions are market-tested and investor-driven. It is true that investment banks are not immune to misconduct. They may engage in insider trading, market manipulation, or conflicts of interest in advisory roles.

However, these irregularities differ fundamentally from the relationship-based favoritism of commercial banking. They are less about personal ties and more about greed, opacity, or structural flaws in financial innovation. This contrast shows clearly that the irregularities associated with relationship banking cannot thrive in the environment of investment banking.

How is relationship banking beneficial 

Even though relationship banking has often been misused, it is simplistic to dismiss it entirely as the root of irregularities. It has several undeniable merits. By reducing information asymmetry, it enables banks to understand clients’ businesses beyond what formal financial statements reveal.

This is particularly important in developing economies, where small and medium enterprises may lack extensive documentation.

Relationship banking also promotes financial inclusion, as trust-based lending enables rural communities and informal enterprises to access credit where collateral is unavailable.

Long-term relationships also provide stability during crises, as banks may support loyal clients through downturns, preventing widespread defaults. Additionally, relationship banking fosters loyalty and profitability, encouraging clients to use multiple services and thereby strengthening banks financially.

Case studies further illustrate the nuanced role of relationship banking. India’s non-performing asset crisis was fuelled by politically connected lending, but the deeper cause lay in weak governance and political interference rather than relationship banking in principle.

The 2008 global financial crisis, by contrast, was less about personal ties and more about systemic greed, flawed instruments, and conflicts of interest between rating agencies and financial institutions. The East Asian financial crisis of 1997, however, did stem directly from excessive relationship-based lending, as banks tied to conglomerates extended unsustainable credit, eventually collapsing together.

The way forward lies in reform rather than rejection. Stronger regulatory oversight is needed to enforce disclosure, credit appraisal standards, and external audits in commercial banking.

Political interference in state-owned banks must be curtailed, while technology-driven credit assessment tools should be adopted to reduce subjectivity. Governance in banks must be strengthened by empowering boards and risk committees to override discretionary decisions driven by personal ties.

Ethical banking culture must also be promoted, distinguishing legitimate trust-based banking from favoritism and holding managers accountable for lapses. 

Relationship banking, when practiced responsibly, fosters trust, reduces information gaps, and supports financial inclusion. However, in many developing economies, it has been stretched into favouritism, cronyism, and political capture, making it a significant driver of irregularities in commercial banking.

In contrast, investment banking operates in a transparent, disclosure-driven, and market-tested environment where such irregularities are structurally impossible.

Relationship banking can therefore be blamed for many irregularities in retail and commercial banking, but it is not the sole root cause. The deeper issues lie in governance failures, political interference, and weak regulatory oversight.

Rather than abolishing relationship banking, reforms must focus on limiting discretion, enforcing transparency, and strengthening institutions so that its benefits can be preserved without allowing it to degenerate into malpractice.