Extractive institutions and banks’ implicit subsidies

Abstract

We investigate whether banks located in countries with extractive institutions benefit from larger implicit subsidies, using a sample of banks from 35 countries. We conjecture that the banking systems in countries with extractive institutions have the political and economic powers to lead governments to absorb banks’ distress risk and use public resources to guarantee banks’ survival in distressed events. This creates ex-ante implicit subsidies that reduce banks’ cost of equity financing in these countries. To reinforce the causal evidence, we explore variations in external democratic capital as an instrument for institutional exploitation. Our results indicate that the less extractive the institutional environment, the lower the banks’ implicit subsidies. In countries with less extractive institutions, regulatory instruments are more likely to be adopted, such as bail-in rules and tighter bank resolution frameworks. These policies reduce regulators’ discretion to use public resources to save distressed banks when these interventions are welfare decreasing, reducing ex-ante implicit subsidies enjoyed by the financial sector.