Political Capital and Moral Hazard

35 Pages Posted: 18 Nov 2009 Last revised: 18 Mar 2010

See all articles by Leonard Kostovetsky

Leonard Kostovetsky

Zicklin School of Business, Baruch College

Date Written: October 1, 2009

Abstract

I investigate the role of moral hazard from government intervention on the risk-taking behavior of U.S. financial institutions prior to the 2008 financial crisis. I use cross-sectional variation in political connections to measure the effect of moral hazard. The central finding is a higher exposure to Level-3 (toxic) assets and lower stock returns during the crisis at firms with politically-connected directors and prior lobbying connections. One extra politically-connected director on a 10-member board corresponds to twenty percentage points in the proportion of firm market value in toxic assets and an extra drop of six percentage points in 2008 stock returns. In order to address endogeneity concerns, I also look at an additional exogenous source of variation in political connections: whether the firm is based in a state represented on the Senate Banking Committee. I find that representation on the committee increases firm risk, even after controlling for firm characteristics through firm fixed effects. The paper focuses attention on the perverse incentives for risk-taking in the financial sector created by government bailouts.

Keywords: moral hazard, financial crisis

JEL Classification: G01

Suggested Citation

Kostovetsky, Leonard, Political Capital and Moral Hazard (October 1, 2009). Simon School Working Paper No. FR 10-05, Available at SSRN: https://ssrn.com/abstract=1507227 or http://dx.doi.org/10.2139/ssrn.1507227

Leonard Kostovetsky (Contact Author)

Zicklin School of Business, Baruch College ( email )

One Bernard Baruch Way
New York, NY 10010
United States

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