Central Bank Intervention and the Role of Political Connections

I just finished reading a new Mercatus Center study by Benjamin M. Blau, “Central Bank Intervention and the Role of Political Connections.”

The findings are summarized:

Background

The study uses data from a full-scale audit of the Fed conducted by the General Accounting Office to examine whether banks with political connections were more likely to receive emergency loans during the financial crisis. The Fed is politically independent, and its decision making, including its loans, should be motivated by the best interest of the credit markets and the economy in general. Nonetheless, this study finds a high degree of correlation between political connections and the likelihood of a bank receiving emergency support from the Fed during the financial crisis.

Key Findings

  • Banks receiving emergency loans spent 72 times more on lobbying expenditures in the decade before the crisis than banks that did not receive loans; 15 percent of firms receiving support from the Fed employed politically connected individuals; for banks that did not get a loan from the Fed, only 1.5 percent had a well-connected employee.
  • Banks that lobbied the Fed or employed politically connected individuals were more likely to receive emergency loans. The study still finds a relationship between political connections and the likelihood of receiving an emergency loan from the Fed even after controlling for bank size and eliminating from the sample firms listed as “too big to fail” by the Financial Stability Board.
  • When controlling for factors like size and designation as “too big to fail,” politically active firms on average received larger loans than banks without political connections.
  • Banks that employed politically connected individuals were generally in debt to the Fed for longer than those that did not have such employees

Conclusion

Explaining why politically connected banks were more likely to receive emergency assistance will require more research, but in view of the Fed’s political independence, there are at least three different possible explanations for the results:

  • Information available to the Fed: The Fed possibly had more information about politically active banks; therefore, awarding loans to those institutions was an easier decision.

  • Voluntary participation by banks: Politically active banks are more likely to seek Federal Reserve loans.

  • Risk-taking by banks: Politically connected firms, because of their ties to those in power, might feel emboldened to engage in riskier behavior that will eventually prompt the central bank to take action when the crisis occurs.

Well worth a read, especially by those who support allowing greater political discretion for bailouts and the like in a banking crisis. As I have argued previously, that position is dependent on an assumption that politicians will act in a non-political manner. If, however, politicians are more likely to bailout banks that are politically connected–as Blau finds–then it seems to me that we’d want to be much more skeptical about allowing politicians to pick winners and losers by deciding who gets bailed out and who doesn’t.

Given that the regulatory burden imposed by Dodd-Frank will be disproportionately expensive for smaller banks relative to large, combined with the potential entrenchment of the TBTF subsidy for large banks (although the jury is still out on this as an empirical matter), I suspect that Dodd-Frank’s ironic legacy will be promote consolidation in the industry, make the TBTF fails even larger and more destabilizing to the economy, and to promote even more of the political entanglements and cronyism described by Blau. What Blau finds is just a subset of the larger problem, in my view–the largest and most politically-connected banks are the ones that can hire the lawyers and lobbyists to cut their way through Dodd-Frank’s thicket of regulation, while smaller banks are being crushed under its regulatory weight and the TBTF subsidy.

In a similar vein, here’s an article from just last month describing how larger banks are gobbling up smaller banks through a wave of mergers and acquisitions, driven in large part by the need amortize the costs of regulatory compliance under Dodd-Frank.

As I argued in that referenced essay: “It is often overlooked that the value of the rule of law is to benefit ordinary citizens.  Wealthy, powerful special interests can hire the lawyers and lobbyists that enable them to thrive in a system defined by loopholes and arbitrary government decision-making.  Ordinary citizens, however, are excluded from these back-room deals.” By increasing the politicization and regulatory burden of the banking industry, in the end Wall Street is likely to be the big winner under Dodd-Frank.