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Open Access Publications from the University of California

Political Incentives for Regulatory Forbearance

  • Author(s): Bonett, Derek
  • Advisor(s): Broz, Lawrence
  • et al.

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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