Political Connections and Financial Stability

Do political connections increase bank risk-taking, or do they work as a financial safety net ex post? Using a data set of lobbying activities by US financial institutions, this paper provides empirical evidence that lobbying activities reduce banks’ risks under the presence of government bailouts. First, I uncover from an event study the fact that political connections and government bailouts collaboratively reduce financial system risks. I find lobbying banks experienced larger drops in their credit default swap (CDS) spreads after major bailout announcements in 2008. Next, I develop a quantitative model of corporate risk-taking and credit risk that can generate multiple equilibria, in which lobbying affects the cost of risk-taking (fundamental channel) and serves as an equilibrium-selection device by raising the anticipated amount of financial support during financial crises (equilibrium-selection channel). According to the estimated model, a one-standard-deviation increase in log lobbying expenses raises default probability by 5 percentage points and reduces asset return volatility by 4 percentage points through the fundamental channel, whereas it reduces default probability by 7 percentage points and asset return volatility by 5 percentage points through the equilibrium-selection channel. In total, lobbying is negatively associated with banks’ risks ex post. Both results indicate the complementary roles of political connections and regulatory efforts to achieve financial stability under the presence of government bailouts. ∗Address: 5757 South University Avenue, 60637, USA, e-mail: [email protected]. This research was supported in part by IFABS 2015 Oxford Travel Grants (IFABS-OXFCONF-1501). I would like to thank my advsiors Ali Hortaçsu, Gregor Matvos, and Zhiguo He for their help and support.