There are two fundamentally different views on how financial sector policies and regulation develop across countries and over time. On the one hand, the public interest view argues that governments act in the best interest of society, ultimately maximising public welfare. Policy mistakes are driven by limited information and inefficiencies in the policymaking process. The private interest view, on the other hand, argues that policymakers, including regulators, act in their own interest, maximising private rather than public welfare. Politicians thus do not intervene in the financial system to further public welfare but in their own interest (Becker and Stigler 1974). The private interest view is at the core of the political economy approach to finance, which “believes that changes in political institutions have a fundamental influence on the historical evolution of financial systems across nations while they are at the same time affected by the distribution of power associated with a specific financial system” (Lambert and Volpin 2018).
In this column we report on recent research in the field of politics and finance, presented at the first London Political Finance (POLFIN) workshop, jointly sponsored by Cass Business School, Systemic Risk Centre at LSE and CEPR, while putting it in the context of the existing literature.
Financial crises and populism
Financial fragility can have important repercussions for the political structure of countries. The socioeconomic fallout from the Global Financial Crisis has often been blamed for the rise of populism in recent years. While aggregate evidence has linked financial crises to the rise of right-wing parties (Funke et al. 2016), two recent studies link financial fragility to the rise of right-wing extremist parties using micro-data. First, Doerr et al. (2020) use micro-level data to relate a banking crisis in 1931 to the electoral rise of the Nazi Party in Germany. Two large banks were at the core of the crisis – Danatbank and Dresdner Bank. Cities with a higher share of firms connected to either bank saw larger income declines, and unemployment rose more. However, only towns and cities affected by the failure of Danatbank (which had a Jewish CEO) show evidence of voting for the Nazis above and beyond economic factors. This can be directly linked to Nazi propaganda blaming the economic and financial crisis on the Jewish population.
Second, Gyöngyösi and Verner (2020) link the post-2008 borrower fragility in Hungary to the rise of the right-wing Jobbik party. Before 2008, a mortgage credit boom in Hungary was driven by Swiss franc loans (lower interest rates), with both lenders and borrowers counting on the Hungarian forint to appreciate vis-à-vis the Swiss franc over time (in line with the Samuelson-Balassa effect). When in the wake of the Global Financial Crisis the forint depreciated, Swiss franc borrowers suffered. Using exogenous variation in the attractiveness of Swiss franc loans, the authors then show how the post-2008 fragility is correlated with the geographic variation in the rise of the right-wing Jobbik party.
Why right-wing rather than left-wing populist parties gain from crises, and what these findings imply for the political fall-out from the COVID-19 crisis, are important questions left for future research.
Private interests in financial regulation
Given how tightly regulated the financial sector is, it is not surprising to see intensive lobbying efforts by the financial industry to influence policy making and regulatory actions. Two papers in the conference provided micro-evidence on how private interests influence the legislative and regulatory process in the US.
Adams and Mosk (2020) use a large, manually collected dataset of campaign letters written to US Congress between 1999 and 2018 in order to derive policy positions of the financial industry on 581 specific bills. Tracking the full process from the initial sponsoring to the passage of a bill, the authors find strong evidence that campaign contributions increase the likelihood of policymaking that is in favour of the financial industry and against the will of the organised consumer groups.
Tenekedjieva (2020) focuses on the US insurance industry and finds that regulators with a post-regulation career in mind may become more lenient towards the firms that they are supposed to regulate. Specifically, using the employment history of insurance commissioners from 2000 to 2018, she ﬁnds that 38% of them work in the insurance industry after their term ends; during their term these commissioners perform fewer ﬁnancial exams per year and the exams they perform have fewer negative consequences for ﬁrms. However, she also shows that this behaviour can be mitigated by tighter revolving door laws.
Both papers have direct policy implications in order to minimise the aggregate private distortions to policymaking and future research can benefit more from concentrating on policy areas, industries and firms with the largest potential of a clash between private and public incentives (‘battlefields’) in order to illustrate how large these private distortions may become.
Gains from political connections
To what extent can links to politicians be used for personal gains? Answering this question is challenging given the endogeneity of such links to the power of politicians. Child et al. (2020) use Donald Trump’s surprise election victory in 2016 to identify the value of sudden connectedness to the US president among S&P 500 ﬁrms with pre-existing ties to the businessman Trump. They show that Trump-connected ﬁrms (though only business, and not socially related) had signiﬁcantly higher abnormal stock returns around the 2016 election than their non-connected counterparts, which translates to $1.2 and $2.4 billion in wealth creation for shareholders. Following Trump’s inauguration, connected ﬁrms showed better performance, were more likely to receive government procurement contracts, and were less subject to unfavourable regulatory actions. Even though one cannot clearly differentiate between a corruption or an information story due to these connections, most anecdotal evidence seems to favour the former.
Political beliefs and financial decisions
While political polarisation has risen over recent years in the US and other countries (Boxell et al. 2017) to the point that political affiliations can bias the perception of objective information (Alesina et al. 2020), an important question is whether this also influences financial decisions. Kempf and Tsoutsoura (2020) present evidence showing that credit-rating analysts are more likely to downgrade a firm when their political party affiliation is the opposite to that of the US president. The novel identification strategy comes from the fact that authors can tease out the variation within the same firm and time point. Analysts’ partisan perception thus aﬀects ﬁrms’ cost of capital and investment policies.
Can local political leaders have an influence on financial outcomes in their cities? Krause (2020) uses regression discontinuity design around local elections in the US that were decided with a tight margin between African American and white candidates to show that when local politicians from minority groups win an election, they make better use of the existing regulations to increase the financial inclusion of such groups. Specifically, mortgage lending to African American loan applicants increases by 6 percentage points after black mayors take oﬃce, with these eﬀects more pronounced for borrowers in low-income census tracts.
Finance and the media
While an expanding literature has focused on the role of the media in financial sector decisions and outcomes (e.g. Dyck et al. 2008, Engelberg and Parsons 2011), disentangling the causal impact of media reporting from the impact of the events themselves is challenging. Knill et al. (2020) first show that Fox News has a clear bias in favour of Republican presidents. Exploiting the fact that the Fox News channel was not available across all of the US, they find that during the George W. Bush presidency, firms led by Republican-leaning managers headquartered in regions into which Fox was introduced shifted upward their total investment expenditures, R&D expenditures, and leverage, compared to firms led by Republican-leaning managers headquartered elsewhere.
Durante et al. (2020) consider media capture by banks. Investigating a sample of top European newspapers and linking them to their creditor banks, they show that newspapers’ coverage of earning announcements from their lender banks, relative to other banks, is signiﬁcantly more likely to be related to proﬁts than losses. This pro-lender bias is stronger for newspapers that are highly leveraged. This bias also carries over to the euro area crisis, when newspapers connected to banks more heavily exposed to stressed sovereign bonds were less likely to portray banks as being responsible for the crisis and to support debt-restructuring measures detrimental to creditors.
These two new studies are a welcome addition to the literature as the discipline of finance has been lagging behind (compared to the economics literature) in terms of accepting the heterogeneity in media coverage and exploring how such biased (partisan or self-interested) media communication may lead to distortions in financial decision making. In the age of ‘fake news’ and incredibly fast spread of news through social media, we need more research to understand whether and how these distortions may persist over the long term.
The current crisis will have not only socioeconomic repercussions for generations to come, but also effects on the political structure of countries (Aksoy et al. 2020). At the same time, the financial sector will not only suffer during this crisis – as many other sectors – but will be critical in the recovery phase. Understanding the influence of political and private interests on financial sector decisions, the role of the media and the impact of legislative and regulatory decisions on political partisanship is important. The COVID-19 shock offers a unique opportunity for researchers in the field of politics and finance, but also comes with an important responsibility to inform the current political decision process with experiences from previous crises.
Adams, R and T Mosk (2020), “Financing legislators”, mimeo.