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Political Incentives for Regulatory Forbearance


Laws on the books must be enforced to have an effect. This means that the political actors charged with this enforcement must have the proper incentives to do so. I assess the political incentives to enforce prudential statutes in the U.S. banking sector. The system is two-tiered, with a common set of federal regulators and 50 individual state regulators simultaneously enforcing the same set of statutes on federally chartered banks and state-chartered banks, respectively. The stronger a regulator's political incentives to enforce said statutes, the less a bank's ``outside'' investors (creditors and minority shareholders) will fear expropriation at the hands of its ``insiders'' (managers and major shareholders).

Part of a bank's cost of capital, then, can be predicted by the incentives of its regulators to properly monitor and enforce banks' compliance with prudential and disclosure requirements. A credible regulator can reduce the information asymmetry, and its concomitant agency costs, between a bank's insiders and outsiders. Without a credible regulatory signal, outside investors aren't able to determine a bank's risk ex ante, and will charge a higher price for their funds to compensate for anticipated levels of undisclosed risk. I construct a series of hierarchical models containing comprehensive bank-level balance-sheet controls and which exploit the variation between the institutional structure of state regulatory agencies. I then present strong evidence that state-chartered banks in states wherein the bank supervisory agency is chaired by a political appointee pay a premium, both for debt and equity financing, compared to federally chartered banks in that same state and compared to state-chartered banks in states where the bank supervisor enjoys independence from elected state officials. This discrepancy in funding costs magnifies in the run-up to a gubernatorial election, and state-chartered banks in states regulated by a political appointee are disproportionately likely to fail just after an election, suggesting a ``political business cycle'' effect. Not only this, but the size of the premium these state-chartered banks pay interacts with many bank-level variables that have political implications, such as the share of a bank's assets comprising relationship-intensive loans to local constituents and the size of its state and municipal bond holdings.

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