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The Power of K: Politically-Targeted Activities, Connections and the Financial System

Journal 35: Zicklin-Capco Institute Paper Series in Applied Finance

Deniz Igan, Prachi Mishra

Has the political influence of the financial industry had any bearing on financial regulation and, ultimately, the recent financial crisis? This paper discusses the findings of recent research that uses a detailed database of the lobbying activities, campaign contributions, political connections and mortgage lending activities of the financial industry from 1999 to 2006 in the United States. The evidence suggests that spending on lobbying by the financial industry and network connections between lobbyists and the legislators were positively linked to the probability of a legislator changing positions in favor of deregulation. Also, hiring connected lobbyists who had worked for legislators in the past enhanced the effectiveness of lobbying activities. In addition, lobbying was associated with more risk-taking during 2000-07 and with worse outcomes in 2008. Finally, lobbying lenders had a higher bailout probability. These findings suggest that actions of politically influential financial institutions may play a role in shaping financial regulation and in the accumulation of risks in the system.

Political influence and the financial system
While political influence can be an important factor shaping regulatory frameworks in any industry, its role in the financial system is particularly interesting to study because the financial industry is one of the most heavily regulated. From a theoretical point of view, government actions to regulate the financial industry are well justified due to market failures that may stem from moral hazard, asymmetric information and systemic risk. See, for instance, Goodhart et al. (1998) and references therein. Yet, in practice, political economy factors may interfere with the process through which specific regulations are designed and implemented [e.g. Kroszner and Strahan (1999)]. Such interference can be linked to financial instability episodes because special interest groups may alter the course of government action in order to tailor the financial regulatory landscape to better fit their own needs and take excessive risks under lax regulations which they help enact [Acemoglu (2009), Calomiris (2009), Johnson (2009)]. Consequently, regulatory failure has been argued to be one of the key contributors in the recent global financial crisis [e.g. Obstfeld and Rogoff (2010)] and such failure is often claimed to be linked to the political influence of the financial industry [Simpson (2007)]. Indeed, the financial industry is also the largest source of politically targeted spending in the United States [Center for Responsive Politics (2009)].

Studying the link between political influence and financial regulation and risk-taking in a formal framework, however, is often constrained by availability of detailed information on politically targeted activities. The case of the United States provides an excellent opportunity to look into the issue in more detail for two reasons. First, it was the epicenter of a systemic financial crisis. Second, there is a wealth of publicly available information on political activities of the financial industry.

This paper gives an account of recent research studying the relationship between the political influence of the finance, insurance and real estate industry (FIRE) and financial regulation and risk taking by politically active financial institutions during 1999-2006 in the United States. In particular, we seek the answers to the following questions. Did politically targeted activities by FIRE have a direct link to the legislative outcomes of the bills on financial regulation? Did legislators’ network connections with the financial industry and the lobbyists affect their decision to support certain proposals? How do network connections relate to the effectiveness of lobbying activities? Did lobbying lenders behave differently from non-lobbying lenders in the 2000-07 period? How did these lenders perform in 2008 when turmoil hit financial markets?

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