A new study examines whether privately-owned banks seek political influence by offering preferred loan terms to corporate borrowers with valuable political connections, showing that such connections do indeed lead to lower interest rates on new loans.

Contrary to conventional wisdom, direct spending by businesses on developing relationships with politicians is relatively low. Even the most aggressive estimates suggest observable corporate political expenditures are in the low billions, an amount that is likely dwarfed by benefits politicians can bestow on firms and industries. A large body of evidence (see also here and here) suggests such gains are not merely hypothetical, with favored firms receiving government contracts, bailouts, lenient regulatory treatment, and credit from government-controlled institutions. So why do firms “underinvest” in political connections? One possible explanation is that the most widely used measures, campaign contributions and lobbying expenses, do not represent the entirety of their engagement in politics.

An important issue, then, is to identify other possible channels through which firms seek political influence that may be less easy to directly observe. Answering this question would help us better understand the extent of, motivation for, and impact of corporate participation in politics. It would also assist policymakers in designing governance and disclosure rules for spending shareholder funds on political activities. Numerous newspaper and public investigations show that hiring is a common tool for establishing political connections, with former and future political insiders serving on boards or in executive functions. A recent paper identifies charitable giving as one additional means of achieving political influence.

In our study, we examine the bank lending channel of political influence. More specifically, we explore whether privately owned banks seek such influence by offering preferred loan terms to corporate borrowers with valuable political connections.

One prominent example of a bank using preferential lending to influence politics is Countrywide Financial. Once the largest US mortgage lender, it offered favored loans with relaxed underwriting standards to the members of Congress, congressional staff, government officials, and directors at Fannie Mae between 1996 and 2008. A report by US House of Representatives shows that Countrywide even deliberately took a loss on a loan provided to Daniel Mudd, the former president and CEO of Fannie Mae, with a Countrywide manager noting that the loss on Daniel Mudd was “expected to eventually generate a benefit for the company.”

Partly in response to the Countrywide affair, many banks instituted strict compliance requirements for any dealings with politicians, which potentially pushed the banks to seek alternative methods of using lending to pursue political influence. For example, rather than entering business deals with a politician directly, a bank can also boost its relationship with the politician by offering better loan terms to firms linked to this politician.

In our paper, we begin our analysis by testing whether banks offer better loan terms to firms that are connected to members of Congress. A major challenge in studying the impact of political connections between firms and politicians is that they are endogenous. For example, firms will tend to support, and potentially benefit from, the election of candidates who share their broad political goals even if politicians never consider the interests of their donors in making decisions. It is also possible that high-quality firms invest more in establishing relationships with politicians, leading to a spurious relation between political connections and credit terms. To address this endogeneity issue, we focus our analysis on close elections, defined as those in which the victory margin is less than 5 percent. The key assumption underpinning this approach is that the ultimate outcome of a close election has a random component and that therefore it constitutes an exogenous change in a firm’s political network.

“Rather than entering business deals with a politician directly, a bank can also boost its relationship with the politician by offering better loan terms to firms linked to this politician.”

Our results show that political connections lead to lower interest rates on new loans. This relation is economically meaningful: each connection is roughly equivalent to an increase in the firm’s credit rating from A to A+. Crucially, such an improvement in credit terms does not seem to be justified by changes in firm fundamentals, which are the same for firms with and without connections. How much do these preferential loans cost the bank? In our sample, we estimate that banks reduce annual interest rates by $54,846 for each connection. This represents a significant expenditure and is more than 10 times greater than the maximum allowed direct annual contribution to a politician of $5,000. Moreover, better loan terms arising from political relationships extend beyond interest rates, with connected firms also enjoying larger loans that are burdened with fewer covenants.

Interestingly, the importance of political connections is a major determinant of their impact. The improvement in loan terms is much greater when politicians sit on important congressional committees (the effect becomes 244 percent stronger), when the firm is among the politician’s top campaign contributors (652 percent stronger impact), and when the firm and politician come from the same state (250 percent stronger impact).

We provide further evidence consistent with the hypothesis that banks engage in preferential lending by focusing on their demand for political favors. If banks provide favored loans in order to develop relationships with politicians supported by borrowing firms, the effect of political connections on loan terms should be greater for banks that have higher demand for political influence. One set of such banks may be those that previously faced high levels of Federal Deposit Insurance Corporation (FDIC) enforcement actions, as politicians can help resolve regulatory issues, alleviate their consequences, or avoid future adverse actions.

In support of this expectation, we find that political connections are more important for banks with a poor FDIC history, with these banks granting significantly (235 percent) greater reductions in interest rates. Bank demand for political influence was also likely greater during the period surrounding the passing and enactment of the Troubled Asset Relief Program (TARP). We show that the impact of political connections is indeed much stronger (625 percent) during this period, as it also is for banks that received government bailouts. Furthermore, such banks not only offer lower rates but also lend more frequently to connected firms.

Overall, our study suggests that banks provide preferential loan terms to clients with political connections of value to the banks. The cost of offering discounts in the form of lower interest rates to connected firms is an order of magnitude higher than the maximum direct contribution to a political campaign. Our results illustrate that in addition to direct benefits, such as government contracts or more favorable regulatory treatment, relationships with politicians may create indirect benefits for firms in their interactions with others hoping to gain access to these relationships. They also demonstrate the difficulty of limiting corporate influence-seeking: if businesses are stopped from contributing directly to politicians, they find other ways of seeking favor with policy makers.