Political Incentives and Financial Innovation: The Strategic Use of Toxic Loans by Local Governments

Mardi | 2013-05-07

Christophe PERIGNON – Boris VALLEE

We examine the toxic loans sold by investment banks to local governments. Using proprietary data, we show that politicians strategically use these products to increase chances of being re-elected. Consistent with greater incentives to hide debt, toxic loans are utilized significantly more frequently within highly indebted local governments. Incumbent politicians from politically contested areas are also more likely to turn to toxic loans. Using a difference in-differences methodology, we show that politicians time the election cycle by implementing more transactions immediately before an election than after. Politicians also exhibit herding behavior. Our findings demonstrate how financial innovation can foster strategic behaviors.