Politics, Credit Allocation and Bank Capital Requirements

Abstract

I develop a theory of political influence on bank lending and capital structure. The idea is that legislators may want to direct bank credit to politically-favored loans that reduce bank shareholder wealth, but generate social and/or political benefits. The regulator, who implements the laws passed by legislators, uses both asset-choice regulation and capital requirements to induce this lending. There are four main results. First, the enacting of credit-allocation regulation should be accompanied by higher capital requirements. Second, when credit-allocation regulation is adopted, political or regulatory hubris in misestimating the bank’s valuation of its lending alternatives can generate “hidden” banking fragility. Third, when politics weighs more heavily in bank regulation, the result is a larger (and more competitive) banking sector with higher capital requirements. Fourth, I analyze the design of an optimal reporting mechanism in which the capital requirement and stringency of credit-allocation regulation are endogenously co-determined in response to a report by the bank of its privately-known profitability. The optimal mechanism shows that political influence on bank credit allocation is stronger when banks are more profitable.

Keywords: politics, credit allocation, banking, financial fragility

JEL Classification: D82, E58