What Drives Bank Bailouts?

Study Shows That Political Interests Play a Major Role

In his memoir Stress Test (Crown, 2014), former Treasury Secretary Tim Geithner offers an impassioned defense of the Wall Street bailout he helped engineer during the height of the 2008 financial crisis, arguing that the bailout was the only way to save the economy from collapse. Geithner, however, acknowledges just how unpopular the decision to bail out the banks that were widely viewed as responsible for the crisis really was, famously observing that “We did save the economy, but we lost the country doing it.”

Public outrage over the Wall Street bailout played a significant role in the 2016 election cycle, with both Democrats and Republicans citing it as an example of Washington’s subservience to special interests and corporate donors. Historically, though, bank bailouts have always been unpopular. In his book The Creation and Destruction of Value (Harvard University Press, 2012), historian Harold James recounts for instance the controversy that surrounded the 1931 bailout of the Austrian bank Creditanstalt, whose collapse helped escalate the Depression and contributed to the rise of the Nazi movement. 

In recent decades, academic and public debates over bank bailouts have largely developed along similar lines: Critics argue that using taxpayers’ money to bail out failing financial institutions that behaved recklessly risks moral hazard, while proponents of bailouts—like Geithner—dismiss such “Old Testament judgments” and claim that bailouts are preferable to the alternative.

Often left out of the academic debate, however, are the political factors that may influence bailout decisions. Since the financial crisis, a number of academic studies have focused on the effects of political interests and lobbying by special interest groups on financial legislation. The degree to which politicians involved in bailout decisions may be influenced by either political interests (such as appealing to special interests, or wanting to increase their chances of being re-elected) or ideological preferences, however, has remained relatively under-studied.

A recent working paper, presented at this month’s Stigler Center conference on the political economy of finance, provides empirical evidence about the political determinants of bailout policies by analyzing capital injections into distressed savings banks in Germany by local politicians. The paper argues that political and personal interests have a “major impact” on politicians’ decisions regarding bank bailouts.

Politicians are less likely to bail out banks before elections
The paper, written by Bo Bian, Rainer Haselmann, Thomas Kick, and Vikrant Vig, relies on a sample of 148 cases in which distressed savings banks in Germany received external capital injections, either from their owners or through an industry association, between the years 1994 and 2010.

Germany’s financial sector is uniquely structured, in that savings banks operate within a set geographical area, don’t compete with each other, and are owned by the local municipalities in which they operate, with politicians often serving as members of their supervisory boards. This gives politicians significant control over the banks they oversee.

Individual savings banks are also interconnected by state-level banking associations, meant to ensure their liquidity and stability. These associations, which together comprise an industry of 429 savings banks with a combined balance sheet of over 1 billion euro, 15,600 branches, and 250,000 employees, operate a safety net for distressed banks: If one bank gets into trouble, other banks step in and provide support. Often, they also force the bank in question to undergo restructuring, possibly even a merger with another bank.

Nevertheless, in some cases local politicians still choose to use taxpayers’ money in order to provide a public bailout of the bank, instead of relying on the associations. The authors suggest this could either be because politicians wish to avoid restructuring that they deem inefficient, or because they base their decisions on personal and political interests. For instance, voters may perceive a bailout as a waste of taxpayers’ money and punish a politician who decides to bail out a bank in a subsequent election.

The authors’ findings point to the latter option: Politicians are 30 percent less likely to inject capital into a distressed bank in the year prior to an election than in a year after an election. Likewise, a bailout is 12 percent less likely to occur if an election is highly competitive. This implies that personal interests, like the desire to be re-elected, have a significant impact on whether a bank gets bailed out. Political ideology, they find, also plays a role in bailout decisions, as capital injections are 20 percent less likely if a politician is a member of a conservative party.

More importantly, the authors find more “lending to friends” taking place in banks bailed out by politicians, which according to Vig serves as another piece of evidence that those bailouts may be driven by politicians’ personal considerations.

“Political considerations seem to be a significant driver in bailout of banks,” said Vig, a Professor of Finance at London Business School, in an email to ProMarket. “Our results suggest that politicians derive substantial private benefits in controlling the bank and this control of bank adversely affects the local economy. Bailouts by politicians have negative implications on the efficiency of credit allocation. And, in aggregate, we find a lower real sector performance in municipalities that are under decentralized political bailouts as compared with those under centralized ones.”

Banks that received public bailouts perform worse
After establishing that politicians decide to inject funds into distressed banks based on political as well as ideological factors, the authors then compare the long-run performance of banks bailed out by the municipalities and banks bailed out by the banking associations.

Banks that received support from the associations instead of public bailout, they find, perform better and are also better capitalized in the years that follow a crisis. Banks that received capital injections from the associations, according to the paper, improved their performance much more in the long run compared to banks that received public support. Banks that received support from the association significantly increased their capital ratio, while banks that received public support were not able to reduce their non-performing loans ratio.

“The negative implications we document may precisely be driven by regulatory capture,” says Vig. “In the case of government intervention as a resolution for bank distress, state-owned banks are preserved and they seem to keep or even expand their lending to connected firms, potentially resulting in detrimental outcomes for the aggregate economy.”

It is possible, of course, that politicians are not primarily concerned with the health of the banks themselves, and that the decision to bail out banks has more to do with the general economic development of the county or city where the banks are located. What the authors find, however, is that bailouts by politicians have negative implications on the efficacy of credit allocation, and that preferential lending also goes up in banks receiving political bailouts as compared with those receiving association bailouts. “The ex-post performance results suggest that the political bailouts tend to be bad for the economy,” explains Vig.

These findings are surprising, the authors note, since politicians are supposed to have a profound knowledge of the banks’ operations due to their membership in their supervisory boards. If politicians took advantage of this knowledge, they argue, there should be a positive effect of bailouts on the local economy.

One caveat is that the study focuses on local politicians and local elections in urban municipalities and rural counties. Local politicians are much closer to the banks, and therefore their decisions are more easily influenced by political factors and ideology, while national politicians are forced to look at things from a broader perspective. This, the authors argue, illustrates “the advantages of larger distance and broader perspective” in designing banking regulations. In the case of Europe, they note, this implies that a unified European banking supervision regime—advocated by many economists and policy makers—could have advantages over a system where the perspective of decision makers may be too narrow.

Though the structure of Germany’s banking industry is unique, according to Vig, the results of the study could apply to other countries, like the U.S. “A lot of people have this view that corruption was just a developing economy problem. Our results suggest that while it takes more subtle forms, it may be quite prevalent in all economies. The advantage of Germany is that it provides very good quality data and the institutional set-up allows us to make causal claims.”

Written by Asher Schechter for and published by ProMarket ~ June 29, 2017.

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