Examining the links between a bank’s performance and its political connections and the economic freedom of its home state, the authors find that bank performance is directly linked with economic freedom.
Political connections have an impact on firm performance, especially in highly regulated industries. Companies undertake multifaceted approaches— networking, hiring ex-regulators, having political shareholders, and making campaign contributions and lobbying expenditures—to get favorable regulations. The authors examine whether political connections provide any measurable benefit to banks in a particular US state and whether these benefits are mitigated by the economic environment of that state.
How Is This Research Useful to Practitioners?
To perform the fundamental analysis correctly from both the equity and the debt perspective, a firm’s business, financial, industry, and regulatory risk must be analyzed. Since the global financial crisis, regulatory scrutiny has been increasing, especially in the financial services industry, and economic freedom has thereby been reduced. The authors find that a state’s economic freedom is highly correlated with firm performance.
The impact, if any, of a firm’s political connections is another important consideration. The authors find that banks generally have higher returns on assets when their headquarters are in a state where a senator or representative serves as the chair on the respective banking committee in Congress. The effect of having the banking committee chair, however, is substantially reduced by higher levels of economic freedom.
The differential return on firms with political connections in less economically free states is abnormally high—up to 11.15% a year. Because of increasing regulations, such discriminatory policies as taxation, and lesser economic freedom, political connections can play a valuable role in predicting stock returns.
How Did the Authors Conduct This Research?
The authors use firm-year observations (SIC Code 6020), including commercial banks, for 1989–2010 from CRSP and Compustat. To measure political connectedness, they focus on only the chair position of the banking committee in the chair’s home state versus all members of the committee. Economic freedom data are from Fraser Institute’s annual state level index. The stock prices and accounting variable data are for banks with total assets greater than $1 billion (i.e., about 410 commercial banks with 3,835 bank-year observations).
To see the impact of economic freedom and political connectedness on bank performance, the authors use descriptive statistics coupled with regression analysis. They use propensity score matching analysis to resolve any self-selection bias. To check bank performance on stock prices, the authors use the buy-and-hold estimate method and cross-sectional regression tests to confirm the results of the asset pricing model. Finally, they confirm the findings using various robustness tests, including checking for heteroskedasticity.
The authors attempt to demystify the fact that political connections, especially in economically free states, always help a firm achieve more growth. In particular, they examine the banking industry, which is undergoing massive regulatory changes globally. Further research could look at other regulated industries, such as pharmaceuticals and utilities, to validate the results.