Banks that Lobby More Likely to Get Emergency Loans from the Fed

President Obama's nomination of Janet Yellen to succeed Ben Bernanke as Federal Reserve chairman is breathing new life into old questions about monetary policy. But in the post-Bernanke Fed, monetary policy extends beyond controlling inflation and interest rates.

As we saw during the height of the financial crisis, the Fed adopted a host of new lending tools designed to shore up ailing banks and revive moribund lending, loaning out trillions of dollars in the process. Whatever the macroeconomic benefits of these novel tools, they provided the means for the Fed to lend out an unprecedented amount of funds. And lend they did.

A July 2011 Fed audit found that it doled out some $16 trillion in loans through these various facilities. By the end of 2008, the amount of outstanding loans peaked at $1 trillion. Of all the questions that one could ask regarding this extraordinary amount of lending, perhaps the most important question is: What factors determined whether or not a bank would receive this largesse? 

My own analysis of 677 financial institutions found that politically active banks — those that employed politically connected individuals, and those that spent more on lobbying—were more likely to get loans from the Fed and were likely to get larger loans than their politically inactive competitors.

For instance, the banks that borrowed from the Fed had lobbying expenditures that were 72 times greater than the lobbying expenditures of banks that did not borrow from the Fed. Moreover, banks that borrowed from the Fed were more than five times as likely to spend money on lobbying as nonborrowing banks. And Fed borrowers were 10 times more likely to employ politically connected individuals than nonborrowers.

Other nonpolitical factors mattered, too. Larger banks, both in terms of assets and market capitalization, were more likely to borrow from the Fed than smaller banks, and banks with more nonperforming loans and loans in foreclosure were also more likely to borrow. Even after controlling for these and other factors that may have influenced the decision of a bank to participate in the Fed's emergency loan facilities, my research found that politically connected banks were 10% to 17% more likely to borrow than nonconnected banks.

At first, these findings are puzzling. But, in fact, after eliminating the five banks that directly lobbied the Fed prior to the crisis, I still found that politically connected banks were more likely to borrow from the Fed than nonconnected banks.

What explains this peculiar result? It doesn't seem likely that the Fed, which operates under some sense of political independence, would be motivated to provide emergency support to certain banks as political favors.

One possibility is that politically connected firms might simply be the types of firms that are more willing to participate in government-sponsored programs like the Fed's emergency lending facilities. Another, perhaps more disturbing, possibility is that banks might view their political connections as an insurance policy, which may encourage more reckless or risky behavior.

In the late 1970s, economist Steven Shavell showed that once individuals become insured, they begin to behave differently. Insured motorists, for example, may be tempted to take less care, knowing that someone else will pick up the costs of an accident. Economists call this the problem of moral hazard.

But this isn't just a problem for the textbooks. In March of 2008, then-Treasury Secretary Henry Paulson assured ABC's George Stephanopoulos, “We're very aware of moral hazard. My primary concern is the stability of our financial system.”

Just seven months later, Paulson decided that the stability of the financial system hinged on a $700 billion bailout known as the Troubled Asset Relief Program, and that it was worth it even if the program induced more moral hazard. Now, several recent economic studies show that Tarp funds were more likely to flow to those banks with stronger political connections.

My own findings suggest that these connections might have made banks more reckless long before anyone gave much thought to an impending financial crisis. Greater risk-taking activity during the good years turned sour during the financial crisis, sending politically connected banks to the Federal Reserve looking for handouts.

To the extent that this is true, it seems as though the moral hazard associated with political connections could be hazardous to taxpayers' wealth.

Benjamin M. Blau is associate professor of economics and finance at the Jon M. Huntsman School of Business at Utah State University and author of a new working paper published by the Mercatus Center at George Mason University, “Central Bank Intervention and the Role of Political Connections."