Do Lenders Favor Politically Connected Firms? Rent Provision in an Emerging Financial Market

Abstract

Corruption by the politically connected is often blamed for economic ills, particularly in less developed economies. Using a loan-level data set of more than 90,000 firms that represents the universe of corporate lending in Pakistan between 1996 and 2002, we investigate rents to politically connected firms in banking. Classifying a firm as political if its director participates in an election, we examine the extent, nature, and economic costs of political rent provision. We find that political firms borrow twice as much and have 50% higher default rates. Such preferential treatment occurs exclusively in government banks - private banks provide no political favors. Using firm fixed effects and exploiting variation across time or lenders, we show that the observed political preference is driven by the political status of the firm and not by any unobserved firm characteristic. The political rents thus identified increase with the strength of the firm's politician and whether he or his party is in power, and fall with the degree of electoral participation in his constituency. We provide direct evidence that rules out alternative explanations such as socially motivated lending by government banks to politicians. The economy wide costs of the rents identified are estimated to be 0.3% to 1.9% of GDP every year.