Politics, Credit Allocation and Bank Capital Requirements

I develop a theory of political influence on bank lending and capital structure. The idea is that legislators may want to direct bank credit to politically-favored loans that reduce bank shareholder wealth, but generate social and/or political benefits. The regulator, who implements the laws passed by legislators, uses both asset-choice regulation and capital requirements to induce this lending. There are four main results. First, the enacting of credit-allocation regulation should be accompanied by higher capital requirements. Second, when credit-allocation regulation is adopted, political or regulatory hubris in misestimating the bank’s valuation of its lending alternatives can generate “hidden” banking fragility. Third, when politics weighs more heavily in bank regulation, the result is a larger (and more competitive) banking sector with higher capital requirements. Fourth, political influence on bank credit allocation is likely to be stronger when banks are more profitable.