Chen et al “the effect of the political connections of government bank CEOs on bank performance during the financial crisis”, j financial stability (2018)

Accepted ManuscriptTitle: The Effect of the Political Connections of Government Bank CEOs on Bank Performance during the Financial Crisis Authors: Hung-Kun Chen, Yin-Chi Liao, Chih-Yung

Accepted Manuscript

Title: The Effect of the Political Connections of Government

Bank CEOs on Bank Performance during the Financial Crisis

Authors: Hung-Kun Chen, Yin-Chi Liao, Chih-Yung Lin,

This is a PDF file of an unedited manuscript that has been accepted for publication

As a service to our customers we are providing this early version of the manuscript.The manuscript will undergo copyediting, typesetting, and review of the resulting proofbefore it is published in its final form Please note that during the production processerrors may be discovered which could affect the content, and all legal disclaimers thatapply to the journal pertain

The Effect of the Political Connections of Government Bank CEOs on Bank Performance during the Financial Crisis✩

Department of Management and Marketing

Western Illinois University

* Corresponding author Tel.: (886) 3-463-8800#6370; Fax: +886-3-4557040

E-mail address: d95723009@ntu.edu.tw (C.-Y Lin)

✩

We are especially grateful for constructive comments from Yan-Shing Chen, Yehning Chen, Tse-Chun Lin, Yanzhi Wang and seminar participants at National Taiwan University for helpful comments and suggestions Chih-Yung Lin appreciates financial support from the Taiwan Ministry of Science and Technology Any remaining errors are ours

ACCEPTED MANUSCRIPT

Keywords: Political connections, government banks, financial crisis, institutional

ownership, country corruption and governance

JEL classification: G01, G21, G28, G34

1 Introduction

In August 2007, the credit markets froze after two hedge funds run by New based Bear Stearns Co collapsed because of the plummeting values of their subprime mortgage holdings The inability to set a price on such securities paralyzed the market

York-At that time, most government-owned banks were encouraged by their governments to increase lending to prevent the collapse of business and to stabilize and promote economic recovery (Laeven and Valencia, 2010, 2013), which resulted in banks acquiring many nonperforming loans that weakened their capital reserves.1 However, not all government banks suffered equally While researchers have been intrigued by the heterogeneous performance of banks during the most recent financial crisis (2007

to 2009) (e.g., Fahlenbrach and Stulz, 2011; Beltratti and Stulz, 2012; Berger and Bouwman, 2013; Ellul and Yerramilli, 2013; Ho, Huang, Lin, and Yen, 2016), we contribute to the literature by providing a new perspective to explore why some government banks’ performance was worse than others during the crisis period

1 For instance, Iannotta, Nocera, and Sironi (2013) find that some European government banks became insolvent following the onset of the global financial crisis

ACCEPTED MANUSCRIPT

We propose that the political connections of government banks CEOs contributed

to risky lending decisions by their banks that influenced the banks’ subsequent performance during the crisis We focus on CEOs because they are the primary influence on government bank lending standards, which affect the banks’ sensitivity to

a crisis (Sapienza, 2004; Khwaja and Mian, 2005; Shen and Lin, 2012) In a theoretical model, Acharya and Naqvi (2012) also show that a manager’s incentives to take excessive risks can induce over-lending decisions and thus sow the seeds of an impending crisis

We follow the previous literature and define government banks as banks with at least 20 percent government ownership (La Porta, Lopez-de-Silanes, and Shleifer, 2002) We divide these banks into two groups by year: we designate banks with CEOs who served as politicians as political banks and those without these types of executives

as non-political banks (Faccio, Masulis, and McConnell, 2006; Fan, Wong, and Zhang, 2007) CEOs with political backgrounds may retain their political connections, even as executives To pursue these political affiliations, such as a future political career, politically connected CEOs of government banks tend to follow the interests of other politicians Further, with the support that politically connected CEOs obtain from other politicians, they may ignore market pressures to report low-quality accounting information or poor operating performance (Chaney, Faccio, and Parsley, 2011) Hence,

we conjecture that political banks may have carried more low-quality loans because of political connections than did non-political banks, either before or during the crisis (the political-connection hypothesis)

To investigate the issue, we compare the loan quality and performance of political and non-political government banks during the global financial crisis by using data from 41 countries We obtain these data from Bankscope The period of the global

ACCEPTED MANUSCRIPT

financial crisis ran from 2007 to 2009 and the period from 2004 to 2006 we term the pre-crisis period (Ivashina and Scharfstein, 2010; Beltratti and Stulz, 2012)

Empirically, the results support the political-connection hypothesis Political banks significantly approved more low-quality loans than did non-political banks before or during the crisis, such that they were confronted with a higher ratio of nonperforming to gross loans during the crisis This ratio indicates that politically connected banks became increasingly inefficient and pursued riskier lending behavior Furthermore, these lower-quality loans caused significant underperformance, as measured by return on assets, return on equities, net interest income to total assets, and the cost-to-income ratio during the crisis years

Our research design, based on the recent global financial crisis, can mitigate endogeneity concerns The financial crisis represents an exogenous shock with a negative effect on all individual firms The crisis resulted in a systematic decrease in loan quality and in the subsequent performance of the banks and thus allows us to employ a difference-in-differences (DiD) analysis We also include bank fixed effects

in our regression models to control for any potential endogeneity concerns arising from omitted variables or measurement error (Roberts and Whited, 2013) However, government banks may choose politically connected CEOs for unobserved bank characteristics or political reasons (Cooper, Gulen, and Ovtchinnikov, 2010), leading to

a self-selection bias.2 We use Heckman’s (1979) two-stage approach to address the self-selection bias that might result from a ruling party choosing politically connected CEOs for government banks (Cooper, Gulen, and Ovtchinnikov, 2010) As a result, our main results remain unchanged after controlling for the potential selection bias

2 In another view, the ruling party can choose politically connected CEOs for government banks (Shen and Lin, 2012), whereby hiring politically connected CEOs for government banks is an endogenous assignment We report the results in Table 5 based on the endogenous assignment assumption

ACCEPTED MANUSCRIPT

We also find that the negative influence of political connections on government banks, which we term the PC effect, can be reduced by the presence in those countries

of institutional ownership and superior institutional factors We find that the PC effect

is diminished if a government bank has institutional ownership We also find that the underperformance of political banks is not observed in countries with strong governance systems or low levels of corruption, which is consistent with the findings

of previous studies that institutional factors in countries have a significantly positive influence on the lending behavior of banks (Qian and Strahan, 2007; Bae and Goyal, 2009; Haselmann, Pistor, and Vig, 2009) This evidence also shows that these institutional factors may in fact exercise sufficient influence to protect banks from political intervention Thus, the inefficient allocation of resources by political banks can be partly controlled by institutional ownership and the specific country’s institutional factors

Moreover, we investigate possible motives for the performance-destructive behavior of government banks with politically connected CEOs, i.e., whether these CEOs grant more low-quality loans for their own benefit, such as enhancing their own future political careers By studying employment renewal as well as whether the CEOs

of government banks were offered a political position after the crisis, we find positive evidence of such motives We find that 22.50% of politically connected CEOs remained

at the same government bank from 2010 to 2013, as compared to only 8.79% of politically connected CEOs; 28.75% of the politically connected CEOs of government banks were offered a political position from 2010 to 2013, as compared to only 4.40%

non-of non-politically connected CEOs Therefore, the CEOs non-of government banks with political connections and poor operating performance are less likely to be penalized by the bank or by the political system These CEOs even had the potential for a successful

ACCEPTED MANUSCRIPT

political career after the crisis This evidence is consistent with our political-connection hypothesis, that the CEOs of government banks used their political power and influence

to relax lending standards and to reap private benefits

Research studies have typically used a macro-level measure, election years, to represent the political factor and to analyze the influence of political ties (Sapienza, 2004; Dinç, 2005; Brown and Dinç, 2005; Micco, Panizza, and Yaňez, 2007; Shen and Lin, 2012; Jackowicz, Kowalewski, and Kozłowski, 2013) The literature shows that politicians obtain more benefits during major elections (Dinç, 2005; Micco, Panizza, and Yaňez, 2007; Iannotta, Nocera, and Sironi, 2013) Different from previous studies,

we focus on a bank-level political factor by considering the previous role of a CEO as

a politician and investigate whether the PC effect is stronger in a major election year

We do not find evidence showing that a major countrywide election aggravates the negative influence of political connections on government banks’ performance, however, indicating that the PC effect still exists after controlling for a major election year

The contributions of our study to the literature are threefold First, we complement the literature on political connections of bank CEOs by investigating their negative influence on government banks The influence of political connections on corporate finance has recently attracted critical attention within industrial firms Most of this literature indicates that the political connections of CEOs add value to firms.3 While these studies have shown that borrowing firms usually use their own political connections to attract favorable loans from government banks (Sapienza, 2004; Dinç,

3 That is, politically connected firms are more likely to obtain preferential treatment when applying for bank loans (Khwaja and Mian, 2005; Charumilind, Kali, and Wiwattanakantang, 2006) to gain an increase in stock returns during the elections (Goldman, Rocholl, and So, 2009; Cooper, Gulen, and Ovtchinnikov, 2010), to be informed in advance on future policy directions (Belo, Gala, and Lin, 2013),

to be the first to be bailed out (Faccio, Masulis, and McConnell, 2006), and so on

ACCEPTED MANUSCRIPT

2005; Carvalho, 2014), we provide evidence that the political connections of lenders could also affect their lending decisions.4 Using global data, we propose a novel viewpoint to show the dark side of political connections from the perspective of the supply side of the financial system.5 This paper thus complements the literature by showing that government banks with politically connected CEOs suffer from lower lending standards.6

Second, we relate political connections to the banking literature on corporate governance and institutional factors We show that the PC effect can be partly eliminated when government banks have institutional ownership This finding contributes to the field of corporate governance in which the presence of institutional ownership reduces the agency problem (e.g., Weisbach 1988; Bhojraj and Sengupta, 2003; Henry, 2008) In addition, previous studies reveal the far-from-ideal track record

of government banks regarding the efficiency of their capital allocations (Sapienza, 2004; Khwaja and Mian, 2005; Iannotta, Nocera, and Sironi, 2007; Ho, Chen, Lin, and Chi, 2016) We find that the influence of the political connections of government bank CEOs is not as strong in countries with better governance and lower corruption levels

4 Government banks tend to charge lower interest rates to firms associated with the ruling party than to those without such an affiliation (Sapienza, 2004) In addition, politicians can use government banks to distribute incentives to their supporters by increasing lending during election periods (Dinç, 2005) and

to use lending to expand employment in politically attractive regions (Carvalho, 2014)

5 Only two studies show the dark side of political connection, that is, Fan, Wong, and Zhang (2007) and Chaney, Faccio, and Parsley (2011) They find that politically connected firms underperform in comparison with non-politically connected firms in terms of post-IPO stock returns and the quality of accounting information reports, respectively Our study complements Fan, Wong, and Zhang (2007) and Chaney, Faccio, and Parsley (2011) by showing that banks with political CEOs would perform worse

6 Hung, Jiang, Liu, Tu, and Wang (2017) find that banks with politically connected CEOs outperform their non-connected counterparts, which is in contrast with ours Although both studies focus on the political view of lenders, we use a sample of global government banks whereas Huang et al (2017) use

a sample of commercial banks in China, which includes both government-owned and privatelyowned banks Our results are in line with prior literature, which has argued that political connections hurt the value of government-owned banks (Sapienza, 2004; Khwaja and Mian, 2005; Iannotta, Nocera, and Sironi, 2007; Shen and Lin, 2012; Shen, Hasan, and Lin, 2014) Hung et al (2017) is consistent with the literature that political connections enhance the value of privately owned firms (Cooper, Gulen, and Ovtchinnikov, 2010)

ACCEPTED MANUSCRIPT

These findings complement those in recent studies that investigate the important role

of corruption in bank lending (Beck, Demirgüç-Kunt, and Levine, 2006; Barth, Lin, Lin, and Song, 2009; Houston, Lin, and Ma, 2011)

Third, this paper complements the literature on bank lending during global financial crises (e.g., Ivashina and Scharfstein, 2010; Puri, Rocholl, and Steffen, 2010; Acharya and Naqvi, 2012; Chen, Chen, Lin, and Sharma, 2016) Although these studies show a substantial decline in the loan supply during crisis periods, little attention has been given to the lending behavior of government banks During the 2007-09 crisis period, we find that the political connections of government banks led to the deterioration of their lending quality and a consequent decline in their operating performance These findings are consistent with the view that the political intervention

of politicians leads to inefficient lending by government banks (Dinç, 2005; Shen and Lin, 2012; Iannotta, Nocera, and Sironi, 2013)

The remainder of this paper is organized as follows We develop our hypotheses

in Section 2 and describe our data and present basic statistics in Section 3 We examine the relationship between the PC effect and bank performance in Section 4 and in Section

5 we examine that between the PC effect and institutional factors Section 6 presents a discussion of the results, and Section 7 concludes the paper

2 Hypotheses development

Government banks played an important role in preserving the stability of financial markets during the global financial crisis (Laeven and Valencia, 2010, 2013) However, not all government banks suffered equally during the crisis This difference raises the question of why some government banks performed worse than others during crisis period

ACCEPTED MANUSCRIPT

The political view suggests that the operations of government banks are constantly being used by politicians to pursue their individual political goals, such as the provision

of jobs, resources, or subsidies to their friends and supporters (Shleifer and Vishny, 1998) Therefore, the maximization of the political benefits to politicians becomes their main objective For instance, several studies have shown that industrial firms often use their political connections to attract favorable loans from government banks (Sapienza, 2004; Dinç, 2005; Faccio, Masulis, and McConnell, 2006; Carvalho, 2014) No studies have as yet taken into account, however, whether the types of political connection of some government bank CEOs might differ from others, so that some banks are aligned with politicians’ interests, but others are not

When government bank CEOs have previously served as politicians, they can retain their political ambitions On the one hand, politically connected bank CEOs are willing to align themselves and their banks with the interests of other politicians to facilitate their future political careers To ensure the success of these careers, politically connected CEOs can grant more low-quality loans that lead to poor operating performance, especially during financial crises

On the other hand, politically connected CEOs of government banks are not penalized for high loan default rates as long as their politician friends can protect them from market pressures To some extent, politicians provide protection to the companies with which they associate by preventing them from being penalized for low-quality accounting information (Chaney, Faccio, and Parsley, 2011) If politically connected government bank CEOs care less about loan quality, they are more likely to lend money

to low-quality borrowers to gain political influence, resulting in an increase in default loan rates and a reduction in operating performance during crisis years

Non-politically connected CEOs of government banks tend to care more about

ACCEPTED MANUSCRIPT

loan quality, which may not align with politicians’ interests These CEOs do not readily take risks by engaging in low-quality loans because they do not have strong support from political friends Moreover, non-politically connected CEOs are not concerned as much as their politically connected peers about a future political career Instead, they may prefer to maintain their current position and carefully participate in lending decisions Therefore, we present our first two hypotheses as follows:

Hypothesis 1: Political banks made more low-quality loans than did non-political

banks before or during the global financial crisis

Hypothesis 2: Political banks performed worse than non-political banks during the

crisis because of the low-quality loans made before or during the crisis

Several studies have shown that the presence of institutional ownership can mitigate agency problems by providing efficient monitoring of managers and by reducing information asymmetry between a firm and its lenders Greater institutional ownership is associated with lower bond yields and higher credit ratings on new bond issues (Bhojraj and Sengupta, 2003) Firms with higher levels of institutional ownership are more likely to terminate poorly performing CEOs and are associated with better valuation (Henry, 2008; Aggarwal, Erel, Ferreira, and Matos, 2011) Some studies also show that the proportion of institutional ownership increases with the quality of the governance structure (Aggarwal et al., 2011; Chung and Zhang, 2011) Therefore, if the presence of institutional ownership has a well-established governance mechanism to discipline managers, it should also reduce the negative influence of political connections Therefore, our third hypothesis is as follows:

Hypothesis 3: The presence of institutional ownership can eliminate the PC effect on

bank performance

ACCEPTED MANUSCRIPT

Studies have also observed that a country’s institutional factors have a significantly positive influence on the lending behavior of banks (Qian and Strahan, 2007; Bae and Goyal, 2009; Haselmann, Pistor, and Vig, 2009) For example, high-quality country governance (e.g., regulatory quality and government effectiveness) is also related to the improved performance of government banks (Boehmer, Nash, and Netter, 2005; Shen and Lin, 2012)

In addition, in countries with high corruption levels, the performance of government banks is severely hampered by political interference (Boehmer, Nash, and Netter, 2005; Shen and Lin, 2012; Shen, Hasan, and Lin, 2014) that impedes banks’ capital efficiency (Beck, Demirgüç-Kunt, and Levine, 2006; Houston, Lin, and Ma, 2011) Overall, these previous studies suggest that government banks in countries with superior governance and low corruption levels and are less likely to lend to low-quality borrowers Thus, our fourth hypothesis is as follows:

Hypothesis 4: Countries’ superior institutional factors can eliminate the PC effect on

bank performance

3 Data

3.1 Sample collection and identification of political banks

Our initial sample is obtained from Bankscope, which contains ownership and accounting data of banks worldwide To avoid the policy effect of government banks, our sample includes only bank holding companies, commercial banks, and savings banks We then restrict our sample to government banks or banks that have greater than

20 percent government ownership (La Porta, Lopez-de-Silanes, and Shleifer, 2002) We check individual bank websites and other publications to identify and verify government ownership

ACCEPTED MANUSCRIPT

Similar to the literature on political connection measures (Faccio, Masulis, and McConnell, 2006; Fan, Wong, and Zhang, 2007), we classify government banks with CEOs or presidents who have served as politicians as political banks; otherwise they are classified as non-political banks We acquire the names of the CEOs or presidents for each government bank from 2004 to 2009 through Bankscope to determine any political bank connections by year We then manually collect background information

on the CEOs or presidents from bank websites, the Wall Street Journal, and the Factiva database to confirm their political experience

We also limit our sample to countries with both political and non-political banks from 2004 to 2009 to avoid sample selection issues The financial performance of all political and non-political banks in the same country are subsequently assessed The final sample comprises 207 government banks in 41 countries from 2004 to 2009 Table

1 presents the definitions for all variables used in this study

[Insert Table 1 here]

Table 2 shows the sample distribution of the selected government banks in 2006.7Most of the sampled countries have only from two to four government banks India, Argentina, andChina have the highest numbers of government banks at 20, 12, and 12, respectively Our sample comprises 96 political banks and 111 non-political banks, as reported in the fourth and the fifth columns of Table 2 China, Taiwan, and the United Arab Emirates have the most political banks at ten, eight, and seven, respectively

[Insert Table 2 here]

influence on lending quality Khwaja and Mian (2005) find that government banks differentially favor politically connected firms by granting them greater access to credit Such preferential treatment damages the lending quality of these banks Research has focused on the political connections between borrowing firms and lenders In the present study, we investigate the influence of political connections on lenders and their loan quality

We use the ratio of nonperforming loans to total gross loans (NPL) as a proxy for

loan quality This proxy measures the portion of banks’ loan portfolios that are in default

or are close to default Nonperforming loans are those with payments of interest and principal that are more than 90 days overdue Various studies have used this proxy as a non-discretionary measure of loan quality (Wahlen, 1994; Liu, Ryan, and Wahlan, 1997; Liu and Ryan, 2006) The higher the ratio of nonperforming loans to total gross loans, the higher are future loan default rates, and the more low-quality loans that are made

ex ante by banks

3.3 Summary statistics

Table 3 shows the summary statistics for our sample during the crisis and pre-crisis periods (from 2004 to 2009) Panel A presents the descriptive statistics All accounting data are winsorized at the top and bottom one percent to avoid potential inference bias because of outliers First, we find that 46.58% of our sample is composed of political

banks (PB) The loan quality, measured by the NPL, on average is 6.22%, with a

standard deviation of 7.21% The mean values of the performance measures are 1.46%

(ROA), 13.87% (ROE), 4.27% (NIM), and 58.22% (C/I)

We then focus on bank characteristics and macroeconomic variables The mean

values of the natural logarithm of total assets (Asset), debt-to-equity ratio (D/E),

loan-ACCEPTED MANUSCRIPT

to-deposit ratio (LOANDEP), and ratio of current assets to total assets (LIQUID) are 8.51, 12.30, 0.8180, and 0.2280, respectively The mean log of GDP per capita (GDP), GDP growth rate (GDP growth), Budget surplus, Inflation rate, and exchange rate changes (Exchange rate) are 8.3064, 0.36%, 17.39%, 6.15%, and 0.24%, respectively

These values are consistent with studies on global banking that examine bank characteristics The first-quarter, median, third-quarter, and standard-deviation values

of all variables are also given in Panel A of Table 3 Panel B of Table 3 presents the correlation coefficient matrix of the variables The results show that correlations between variables in general are very small, making multicollinearity less of a concern [Insert Table 3 here]

4 CEO political connections and bank operating performance

4.1 Univariate analysis

Table 4 presents a comparison of the characteristics and performance of political and non-political banks during the pre-crisis period (2004–2006) and during the crisis period (2007–2009), with Panel A focusing on the bank characteristics and Panel B on bank performance Panel A of Table 4 shows that political and non-political banks have similar characteristics during the pre-crisis period, which confirms that non-political

banks are appropriate benchmarks for political banks The differences in Asset, D/E,

LOANDEP, and LIQUID are also insignificant

[Insert Table 4 here]

Panel B of Table 4 shows that the differences in performance between political

and non-political banks are all insignificant during the pre-crisis period The NPLs for

political banks, however, are significantly higher than those of non-political banks during the crisis period Given the same bank characteristics and loan change rates in

ACCEPTED MANUSCRIPT

both pre-crisis and crisis periods, we can infer that political banks lowered their loan

quality ex ante such that their NPLs became higher than those of non-political banks

when the market crashed Thus, non-political banks outperformed political banks to

some extent during the crisis period For example, the ROEs of political banks

deteriorated during 2008 and 2009.8 Similar results are obtained for the ROA and NIM

confirming that the political connections of government banks resulted in poor bank

performance during the crisis Finally, the performance differences of C/I are insignificantly positive during the crisis Therefore, the PC effect of C/I is weaker than

that of the other three variables In sum, the univariate analysis results align with our Hypotheses 1 and 2, that political banks made more low-quality loans and performed worse than non-political banks during the global financial crisis.9

4.2 Multivariate analysis

In this subsection, we conduct a multivariate analysis to re-examine Hypothesis 1 and to control for some variables that might influence bank performance We employ a DiD analysis to measure the influence of political connections on government banks The econometric model is as follows:

differences between in leverage (D/E) between political banks and non-political banks during the crisis

period are negative, while the value in 2009 is significant with a 10% level

9 It is possible that these banks make low quality loans because they had a higher interest burden to cope with compared to other banks, but not necessarily because they were lending to firms that favored by politicians However, as shown in Panel B of Table 4, the difference in ratio of net interest income to

total assets (NIM) between political banks and non-political banks is insignificant for each year from

2004 to 2006 Based on the results of NIM, we find no evidence that political banks make low quality loans in exchange for higher interest

ACCEPTED MANUSCRIPT

profitability measures (ROA, ROE, and NIM) and one cost measure (C/I), PB ij is a

dummy variable that equals one if bank i in country j is a political bank, and zero for

all other cases, 𝐶𝑟𝑖𝑠𝑖𝑠𝑡 is a dummy variable that equals one if the end of a bank’s fiscal

year, t, is within the crisis period (2007–2009), and zero otherwise, and

𝒁𝒊𝒋𝒕−𝟏 represents a vector of control variables containing bank characteristics and five

macroeconomic variables from bank i in country j at year t-1 The control variables for bank characteristics are Asset, D/E, LOANDEP, and LIQUID; and the five macroeconomic variables are GDP, GDP growth, Budget surplus, Inflation rate, and

Exchange rate All control variables in this study are suggested by Dinç (2005),

Iannotta, Nocera, and Sironi (2007), and Shen and Lin (2012) In the regression

analyses, the t-statistics based on standard errors are adjusted for heteroskedasticity and

are clustered at the country level (White, 1980; Petersen, 2009) Moreover, 𝜈𝑖 captures bank fixed effects, while 𝜀𝑖𝑗𝑡 is the random error To save space, the coefficients of the bank dummies are not reported

Table 5 shows the multivariate analysis results In Model (1), we examine whether political banks approved more low-quality loans than did non-political banks before or during the crisis by focusing on the interaction term between 𝑃𝐵𝑖𝑗 and 𝐶𝑟𝑖𝑠𝑖𝑠𝑡 Sapienza (2004) finds that government banks charge lower interest rates to firms associated with the ruling party than to others Dinç (2005) also shows that, unlike private banks, government banks increase their lending during election periods The PC effect therefore emerges from corruption or related lending behaviors We thus conjecture that political banks tend to increase their loans to politicians, related parties,

or their party supporters with loose lending standards, making them more vulnerable to the shock of a crisis Hence, the nonperforming loans of political banks could have

ACCEPTED MANUSCRIPT

increased more than those of non-political banks during the crisis period.10

[Insert Table 5 here]

Consistent with our conjecture, we find that the coefficient of the interaction term

𝑃𝐵 × 𝐶𝑟𝑖𝑠𝑖𝑠 (𝛼3) has a significantly positive association with NPL, which shows that

political banks, on average, experienced 1.2948% higher nonperforming loans than non-political banks during the crisis period It implies that political banks significantly approved more low-quality loans than did non-political banks before or during the crisis (H1) As the average total loan amount in our sample is about $31.049 million dollars, political connection of government banks led to an increase of $0.4020 (0.4020=31.049×1.2948%) million dollars in nonperforming loans during the crisis The finding indicates that the PC effect is both statistically significant and economically meaningful

In Models (2) to (5), we further determine whether political banks that approved more low-quality loans caused the poor performance of political banks during the crisis period We find that the coefficients of the interaction term 𝑃𝐵 × 𝐶𝑟𝑖𝑠𝑖𝑠 (𝛼3) have

a significantly negative association with ROA, ROE, and NIM, and the tstatistics are

-2.83, -2.50, and -2.09, respectively For example, the coefficient on the interaction term

𝑃𝐵 × 𝐶𝑟𝑖𝑠𝑖𝑠 (𝛼3) with respect to ROE, -4.6081, shows that political banks, on average, experienced a reduction of 4.6081% in ROE over non-political banks during

the crisis period Although the 𝑃𝐵𝑖𝑗 (𝛼2) coefficient on C/I is not significant, the sign

remains positive These findings support our Hypothesis 2, that the political connections of government banks worsened their performance during the financial

10 Wahlen (1994) finds that a high ratio of NPL is associated with low loan quality Liu, Ryan, and Wahlan (1997) and Liu and Ryan (2006) indicate that NPL information is contemporaneous and less discretionary about loan defaults because banks are required to disclose NPL Hence, the ratio of NPL is

the most appropriate and available measure for overall loan quality

ACCEPTED MANUSCRIPT

crisis The coefficients of the bank characteristics and macroeconomic variables are also consistent with our expectations

In sum, a synthesis of the results confirms our conjecture that political banks increasingly introduced low-quality lending before or during the crisis, which resulted

in poor operating performance Our results thus show that inefficient lending behavior stemming from political influence explains the PC effect

To address the potential self-selection bias, we use Heckman’s (1979) two-stage approach In the first stage, we perform a probit regression using 𝑃𝐵𝑖𝑗 as the

dependent variable Four bank characteristics (Asset, D/E, LOANDEP, and LIQUID)

and country dummies are used as independent variables to assess the possible motives for government banks to build political connections The resulting inverse Mill’s ratio (IMR) is inserted into the second-stage regression to correct for any potential bias

Table 6 presents the results of the second-stage regression based on Equation (1) The results in Table 6 are broadly consistent with those in Table 5 For example, the coefficients of the interaction term 𝑃𝐵 × 𝐶𝑟𝑖𝑠𝑖𝑠 (𝛼3) have a significantly positive

association with NPL and a significantly negative association with ROA, ROE, and NIM

ACCEPTED MANUSCRIPT

These findings confirm that the low loan quality of political banks led to their underperformance during the crisis This evidence indicates that our main results are not driven by a self-selection bias

[Insert Table 6]

4.4 Robustness: Control government ownership

Several prior studies have confirmed that bank performance is worse when government control is more pervasive (e.g., greater than 50 percent) Thus, it is reasonable to assume that politicians are appointed as CEOs when the government stake

is particularly high (50 percent or more) If this is the case, most of the results in this study could be explained by the size of the government stake (as opposed to CEOs’ political connections) Therefore, in this section, we additionally control for government ownership to rule out the latter’s influence

We employ a DiD analysis, which is designed to measure the influence of political connections on government banks by controlling for government ownership The econometric model is as follows:

𝑃𝐸𝑅𝐹𝑂𝑅𝑀𝑖𝑗𝑡 = 𝛼1+ 𝛼2𝑃𝐵𝑖𝑗 + 𝛼3 𝑃𝐵𝑖𝑗× 𝐶𝑟𝑖𝑠𝑖𝑠𝑡+ 𝛼4 𝐶𝑟𝑖𝑠𝑖𝑠𝑡

+𝛼5𝐺𝑂𝑖𝑗 + 𝜷′𝒁𝒊𝒋𝒕−𝟏+ 𝜈𝑖 + 𝜀𝑖𝑗𝑡, (2)

where PERFORM ijt is substituted by NPL, ROA, ROE, and NIM, and C/I, PB ij is a

dummy variable that equals one if bank i in country j is a political bank, and zero for

all other cases, 𝐶𝑟𝑖𝑠𝑖𝑠𝑡 is dummy variable that equals one if the end of a bank’s fiscal

year, t, is within the crisis period (2007–2009), and zero otherwise, 𝐺𝑂𝑖𝑗 is

government ownership of the bank i in country j, and 𝒁𝒊𝒋𝒕−𝟏 represents a vector of

control variables

ACCEPTED MANUSCRIPT

Table 7 presents the results based on Equation (2) After controlling for government ownership, the results in Table 7 are broadly consistent with those in Table

5 For instance, the coefficients of the interaction term 𝑃𝐵 × 𝐶𝑟𝑖𝑠𝑖𝑠 (𝛼3) have a

significantly positive association with NPL and a significantly negative association with

ROA, ROE, and NIM again This evidence indicates that our main results are not driven

by size of the government’s stake

[Insert Table 7]

5 Institutional ownership, institutional factors, and CEO political connections

5.1 Institutional ownership and the PC effect

Because institutional ownership can provide an efficient monitoring mechanism for the self-interest of managers (Henry, 2008; Aggarwal et al., 2011; Chung and Zhang, 2011), we hypothesize that the PC effect should be diminished if a government bank has more than ten percent privateinstitutional ownership.11 To test this issue, we divide our sample into two subgroups, banks without and with institutional ownership, and

reexamine the PC effect by applying Equation (1)

Table 8 presents the results regarding the influence of private institutional ownership on the PC effect.12 Panels A and B present the samples of banks without and with institutional ownership, respectively The coefficients of the interaction term

𝑃𝐵 × 𝐶𝑟𝑖𝑠𝑖𝑠 (𝛼3) in Panel A have a significantly negative association with ROA,

ROE, and NIM and a significantly positive association with C/I By contrast, in Panel

B, the coefficients of the interaction term 𝑃𝐵 × 𝐶𝑟𝑖𝑠𝑖𝑠 (𝛼3) are all insignificant

These results confirm our Hypothesis 3, that the presence of institutional ownership can mitigate or eliminate the negative impacts of political connections in government banks Therefore, our results are aligned with the literature that institutional ownership can provide an external monitoring mechanism to reduce the self-interest of managers.13

[Insert Table 8 here]

Greater government ownership is associated with low institutional ownership, which could influence the results of Hypothesis 3 Thus, we add a control for government ownership in Table 8 to rule out the latter’s influence For brevity, we do not report the estimated results; however, they remain similar to those reported in Table

8, which confirms that the PC effect is diminished in banks with institutional ownership

5.2 Institutional factors and the PC effect

Scholars suggest that institutional factors affect the behavior of banks across countries Using country-level institutional factors, such as strength of the country governance system and corruption level, we examine whether countries’ superior institutional factors can eliminate the negative influences of political connections on government banks

We initially apply the Worldwide Governance Indicators (WGI) compiled by Kaufmann, Kraay, and Mastruzzi (2007) as our country governance index.14 We classify the sample countries as having either strong or weak governance based on a

13 The question may be raised as to why institutional investors want to invest in government banks, given that some of those banks may make poor lending decisions due to political connections One potential motivation is because institutional investors are potentially controlling shareholders when government banks are undergoing privatization (Megginson, 2005; Boehmer, Nash, and Netter 2005; Bonin, Hasan, and Wachtel, 2005; Boubakri, Cosset, Fischer, and Guedhami, 2005; Clarke, Cull, and Shirley, 2005) Other than the role of corporate governance, however, the motivation for institutional investors to invest

in government banks could be an interesting topic for further research

14 Considering the increasing importance of country governance, Kaufmann, Kraay, and Mastruzzi (2007) updated their WGI The WGI involves six dimensions of governance, namely, regulatory quality, rule of law, control of corruption, political stability, absence of violence, voice and accountability, and government effectiveness, and covers 212 countries from 1996 to 2006

ACCEPTED MANUSCRIPT