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Political Intervention in Financial System Development: Its Nature, Causes, and Consequences

Fenghua Song's picture

Political intervention in credit markets, often with telling consequences, seems to be ubiquitous, regardless of the stage of development of the financial system. It has been well documented that in emerging markets, cozy ties between banks and politicians, as well as state ownership of banks, give rise to a great deal of political influence in credit extension and capital allocation. The recent financial crises in U.S. and the Eurozone have demonstrated that even advanced financial systems are not immune to political intervention.

In our recent paper, “Notes on Financial System Development and Political Intervention,” we examine how the nature of political intervention evolves during the course of financial system development, as well as its consequences for the evolution and the risk of the financial system. We begin with a discussion of underlying causes of political intervention. One motivation for political intervention is that it may enhance the likelihood of getting the politician re-elected. The idea is that being able to tout expanded credit availability as a benefit generated for potential voters allows politicians to curry favor with their voter base and increase the odds of being re-elected. Even apart from such private benefits, politicians may be philosophically aligned with the idea that having credit available to a broader set of people is a good social goal. For example, the idea of universal homeownership for Americans has been appealing to many U.S. politicians, and this may induce them to push banks to expand credit availability to more Americans to enable a higher number of home purchases.

We then examine the nature of political intervention at different stages of financial system development, given the political goal of expanding credit availability to a larger body of borrowers (possibly with low credit qualities). We use the bank’s cost of raising equity capital from the financial market (to support its lending) to index the stage of financial system development, with the cost declining as the financial system develops from a primitive stage to an advanced stage.

In the early stage of financial development, the cost of equity capital is high, so intervention in the form of government ownership of banks in exchange for direct capital subsidies to banks is very effective in expanding credit availability. This is because banks value subsidized equity capital highly at the early stage due to the high cost involved in raising capital directly from a competitive financial market. As a result, bank lending is very responsive to a capital subsidy. In the advanced stage, capital subsidy becomes less effective because the cost of equity is low anyway: bank lending thus becomes less responsive to a capital subsidy. However, increased bank profitability in a highly developed financial system enables the government to enact direct lending regulations that mandate that banks invest in high-risk borrowers, even if doing so imposes a loss on the banking sector, since banks have enough of a “profit cushion” from other activities to absorb these losses. In the intermediate stage of financial development, neither is bank capital sufficiently costly to make an equity subsidy attractive to banks, nor are the banking sector’s profits sufficiently high to absorb the losses imposed by direct lending regulations.

Thus, political intervention in banking exhibits a U-shaped pattern: it is most notable in underdeveloped and highly developed financial systems, albeit in different forms.

What are the consequences of such intervention? At the early stage of financial development, government ownership weakens a bank’s incentive to improve its screening precision, since the bank does not bear the full cost of imprecise screening. As a result, despite its lending scope being expanded, the banking sector does not experience the same evolution boost (which arises from improved bank screening) that it would have experienced had its lending scope expanded in the absence of government ownership.  In fact, the larger the government equity subsidy, the less likely it is that the banking sector will improve its screening precision. Thus, political intervention at the early stage of a financial system may retard its development. Moreover, because the expansion of the banking sector’s lending scope is not accompanied by a concomitant increase in bank screening, systemic risk in the financial system increases as well.

At an advanced stage of financial development without government ownership, although banks bear the full cost of imprecise screening as they lend to risky, previously-excluded borrowers under the lending regulations imposed by the government, they will not increase their screening precision by investing more in the screening technology. To see why, note that if banks were to improve their screening precision when they are compelled to expand their lending scope, they would have done so voluntarily even without such regulatory pressure. The reason why banks had chosen not to lend to those highly risky (previously excluded) borrowers in the first place is because the marginal benefit of improved screening is outweighed by its marginal cost. Direct lending regulations compel banks to lend but do not fundamentally alter this cost-benefit tradeoff. As a result, political invention at an advanced stage of financial system development also increases financial system risk, as it does at the early stage.

To summarize, we showed that despite expanding credit access, politically motivated intervention in credit markets results in an increase in the risk of a financial system but does not necessarily contribute to the evolution of the financial system. Thus, discussions of financial system stability cannot proceed without explicitly considering political incentives to undertake initiatives that inadvertently increase financial system risk.