Lobbying for the crisis

Prior to the crisis the financial industry spent billions of dollars on lobbying activities. Three economists with the IMF have scrutinized the consequences of this spending spree. Their empirical paper comes to a galling conclusion.

These are busy times for lobbyists working on behalf of banks. The financial industry is trying hard to thwart tougher regulation on pay, capital requirements and taxes.

Judged by historical precedent, let’s hope that their arguments are not taken too seriously by politicians. Lobbying of the financial industry in itself was a cause of the financial crisis, three economists with the International Monetary Fund (IMF) conclude in a striking paper. “Our analysis suggests that the political influence of the financial industry can be a source of systemic risk,” Deniz Igan, Prachi Mishra and Thierry Tressel assert in their empirical study entitled „A Fistful of Dollars: Lobbying and the Financial Crisis“. Policymakers wanting to avoid similar crises in the future should cushion the political connections of the banking industry, the economists recommend. Additionally, the financial regulators should monitor the lobbying activities of the financial sector much more closely.

Prior to the financial crisis, the financial industry spent vast amounts on lobbying. Between 2003 and 2006 the companies pumped almost 1.4 billion dollars in their efforts to influence policy makers. Additionally the  financial industry was one of the most generous campaign contributors. In 2005 and 2006, for example, banks donated 5.3 billion dollars to political parties in the US.

The goal of all those lobbying effert was clear: heading off tougher regulation of the subprime mortgage market. And the money was not spent in vain.  In Georgia and New Jersey, for example, the banking lobbyists managed to stop new consumer protection laws which would have made the life of loan sharks much more difficult.

In their paper Igan, Mishra and Tressel managed to reveal a striking pattern. The more a particular bank spent on lobbying the riskier its lending activity was. Those financial institutes which were the most aggressive subprime lenders were also most keen on influencing policy makers. For example, their loan-to-income ratio was much bigger. This is an indication that these lenders cared less about the credit-worthiness of the borrowers. At the same time they securitized a much bigger proportion of their loans than their competitors did. Securitization allowed passing the credit risk on to other investors. As several other papers (see here and here) have shown, securitization was one of the reasons why mortgage banks did not care too much about the credit-worthiness of their lenders since they knew that they did not have to bear the default risk of those mortgages.

The paper is in line with a number of studies on the effects of lobbying and political connected firms. Recently quite a few economists have shown that close connections to politicians really pay off for companies. Politically connected firms are able to gain unfair competitive advantages at the expense of the general public. From a macroeconomic perspective political patronage of certain companies is causing significant distortions. For instance, unproductive companies are rescued at the expense of the taxpayer. A cozy relationship with politicians also induced corporate slack.

For example, Mara Faccio with Purdue University, showed in an empirical paper based on 450 politically connected firms in 35 countries in 2006: When companies are facing a crisis, good connections to politicians really matter. Firms with close ties to the governments are rescued twice as often by the state as comparable firms without those connections. This is even more surprising given the fact that the first group of firms usually are much more inefficient. „Bailouts of connected firms are even more wasteful than bailouts in general”, Faccio concludes in her paper entitled “Political Connections and Corporate Bailouts” („Journal of Finance“, 2006) “The inefficiencies are two dimensional: first, bailouts of connected firms are more frequent than bailouts of non-connected firms, meaning that funds are misallocated more often; and, second, bailouts of connected firms represent an even less efficient allocation of capital than
are bailouts of non-connected firms.”

Scrutinizing the relationship between lobbying and the financial crisis is a rather delicate task. Reliable data on the subject is in short supply. The paper by Ignan, Mashra and Tressel is based on a new dataset that the researchers manually compiled from a number of sources. Among others, they used information about campaign contributions and the lobbying outlays – figures which are publicly available in the United States. Since 1996 all lobbyists working in Washington have been compelled to report their clients, their revenues and the topics they are working on. Igan, Mishra and Tressel matched these information with detailed figures about the lending activities of individual banks. The result is a unique dataset which allows analyzing the lending behavior of 250 mortgage banks and their lobbying activities at the same time.

The correlations the IMF economists reveal are striking. “Financial intermediaries’ lobbying activities on specific issues are significantly related to both their mortgage lending behavior and their ex-post performance,” the researchers assert. Loans originated by intensively lobbying banks had a much higher default rate after the housing bubble burst. Additionally, the shares of the lobbying banks were battered much more in the crisis. “Lobbying financial institutions lost on average 6.7 percent more in value during the 2007 events than other financial institutions; and 16.6 percent more in value during the 2008 events”, Igan, Mishra and Tressel observe. “The results suggest that these financial institutions were significantly more exposed to bad mortgage loans than other financial institutions.”

Pure correlations, of course do not imply causality. Possibly there are different things that influenced the lobbying activities and the lending behaviour of  the financial institutions at the same time. The IMF economists dig deep into this question but fail to find evidence for that hypothesis.

How can the observed pattern be explained? The IMF economists fail to deliver a final and scientifically solid answer. They presume that close political connections might have made the bankers carefree and overconfident. Financial institutions with a cosy relationship to politicians may have reckoned with a bailout by the government. This trust might have resulted in a riskier lending behaviour and reckless short run profit maximizing.

Such considerations are not made up out of thin air, a different empirical paper shows. Atif Mian, Amir Sufi and Francesco Trebbi with the University of Chicago Booth School of Business analysed how individual members of congress voted on the TARP rescue package in October 2008. Their paper entitled “The Political Economy of the U.S. Mortgage Default Crisis” is forthcoming in the “American Economic Review” , one of the most renowned economic journals.

Mian, Sufi and Trebbi wanted to know which factures influenced the posture of a parliamentarian towards the bailout: Did the political and the economic situation in their constituency matter? Had campaign contributions by the financial industry any impact on their behaviour? Given the fact that the vast majority of Democrats voted in favour of the banking rescue, the economists focused on the Republicans. The more campaign contributions a conservative member of congress recieved, the more likely he was to vote in favour of the bailout plan. The same was true when banks and other financial service providers were an important employer in the constituency of the politician.

All in all the research tells a broad message: Arguments by lobbyists paid by the banking industry really should be taken with a grain of salt.

A German version of this article is available on Handelsblatt.com

(c) Olaf Storbeck, 2010. All rights reserved.