TARP INVESTMENTS: FINANCIALS AND POLITICS

We investigate the determinants of capital allocation to financial institutions under the Troubled Asset Relief Program (TARP). We find that banks’ political ties played a significant role in TARP fund distribution. Connections to Congressmen on finance committees and representation at the Federal Reserve via board members are positively related to banks’ likelihood of receiving TARP capital. The TARP investment amounts are positively related to banks’ political contributions and lobbying expenditures. The effect of political influence is stronger for underperforming banks, thus shifting capital toward weaker institutions. Overall, we provide evidence about various channels through which political activism affects government spending.  We thank Kenneth Ahern, Oleg Chuprinin, Martjin Cremers, Daniel Ferreira, Ron Masulis, John Matsusaka, David Robinson, Stijn Van Nieuwerburgh, and the participants at the WFA 2010 Meetings in Victoria, the FIRS 2010 Conference in Florence, and the FMA-Europe 2010 Conference in Hamburg. We also thank Satish Arcot and Gaurav Mani for research assistance. 2 The Troubled Asset Relief Program (TARP), initiated in October 2008 to combat the financial crisis, authorized the U.S. Department of Treasury to invest federal capital in financial institutions. However, the legislation specified loose guidelines with respect to what assets will be purchased, how they will be valued, and how these funds can be used by financial institutions. According to an independent valuation report by the Congressional Oversight Panel, the Treasury substantially overpaid for its investments under TARP in 2008, effectively subsidizing select banks. In this paper, we study which institutions were more likely to receive these funds. In particular, we examine whether banks’ political activism affected federal funding and whether capital investments were made in stronger or in weaker financial institutions. Our main goal is to investigate the effect of banks’ political ties, campaign contributions, and lobbying activity, if any, on the likelihood and amount of federal investments. One hypothesis is that banks with stronger political connections received favorable treatment in capital allocation. This view would be consistent with theories on the politics of government ownership and investment (for example, Shleifer and Vishny 1994), which suggest that federal capital would be used to accommodate private interests of politicians, such as transferring resources to favored institutions (for example, banks in politicians’ voting districts). However, according to an alternative hypothesis, public scrutiny of banks’ political actions, as well as the review and audit of TARP investments, would negate and even reverse the attempts to influence government decisions. For example, career concerns of federal officials under close monitoring (Fama 1980) represent one mechanism limiting the efficacy of banks’ political activity. In fact, government officials may treat investments in connected institutions with extra caution to defend themselves against future accusations. Our second goal is to investigate the relation between banks’ financial strength and the likelihood of receiving TARP investments. One hypothesis is that capital investments were made in the strongest financial institutions with better earnings, lower risk, and higher capitalization. Retaining the healthiest banks in the financial system would be consistent with the theoretical framework in Atkinson and Stiglitz (1980) and Stiglitz 1 The U.S. Government Accountability Office (GAO) provides the following summary about the use of TARP capital by largest participants: “With the exception of two institutions, institution officials noted that money is fungible and that they did not intend to track or report CPP capital separately. ” GAO Report to Congressional Committees, December 2008, p. 25. 2 Valuing Treasury’s Acquisitions: A Congressional Oversight Panel Report, February 6, 2009, p. 4-5. 3 (1993), in which government aid improves economic stability and social welfare. This view is also consistent with the program’s objective to invest in banks that are “sound and not in need of government subsidization. ” On the other hand, anecdotal evidence from the financial media suggests that at least some federal investments were made in weaker banks to prevent their failure and avoid bank runs (Appelbaum 2008). According to these claims, banks with weaker earnings, lower capitalization, and higher risk would be more likely to receive federal funds. Under this scenario, government aid programs would subsidize underperforming institutions, resulting in misallocation of capital, an outcome predicted by Banerjee (1997) and Hart, Shleifer, and Vishny (1997). The government may also choose to subsidize larger (or more systemically important) institutions because their collapse would threaten the overall stability of the economic system. Our empirical analysis focuses on the Capital Purchase Program (CPP), the largest TARP initiative by the number of participants and the amount of expended capital. This program, initiated in October 2008 and closed in December 2009, invested $204.9 billion in 714 financial institutions. To measure political influence, we introduce four variables at the level of bank regulators and the federal government. Our first measure approximates political influence on the Federal Reserve, which was involved in the initial review of applications from the vast majority of qualified banks. We consider a qualified financial institution (QFI) to be connected to the Federal Reserve if an executive from this QFI held a seat on the board of directors at one of the twelve Federal Reserve Banks or their branches during the administration of CPP. Our second proxy is a bank’s connection with a House member serving on the Congressional Committee on Financial Services and its subcommittees on Financial Institutions and Capital Markets, which played a significant role in the development of TARP and its amendments. We consider a bank connected with a House member if it is headquartered in the representative’s election district. As another measure of political influence, we use a bank’s size-adjusted amount of campaign contributions to congressional candidates. Finally, our fourth proxy for political activism is size-adjusted lobbying expenditures by financial institutions. 3 Valuing Treasury’s Acquisitions: A Congressional Oversight Panel Report, February 6, 2009, p. 5. 4 We find that political connections are positively related to the likelihood of receiving CPP funds, controlling for other bank characteristics. This evidence appears whether political connections are measured via board seats at the Federal Reserve or ties with House members serving on key finance committees. The estimated magnitudes of political influence are substantial: a board seat at a Federal Reserve Bank is associated with a 35.8 percent increase in the likelihood of receiving CPP funds, while a bank’s connection to a House member on key finance committees is associated with a 18.2 percent increase, controlling for other factors. However, strong political connections might be indicative of banks' size and financial condition (sample selection) or of their systemic importance. We consider these alternatives and find that our results are robust to sample selection and banks’ systemic importance. To address sample selection, we repeat our analysis after excluding the largest banks, banks headquartered in New York, and banks with the best or worst financial condition, and obtain similar results. We also identify banks that announced their decision not to participate in CPP. Using propensity scores estimated from these non-participants, we construct a sample of likely applicants, which approximates the officially declared number of CPP applications. Our results remain very similar. To accommodate the possibility that our political measures proxy for systemic importance, we reestimate our tests in samples matched on bank size and on bank size within the same home state, and obtain similar results. We also estimate systemic importance of financial institutions using ∆CoVaR, a measure proposed in Adrian and Brunnermeier (2009), and find that our conclusions persist. It is also possible that a bank’s representation on the board of the Federal Reserve or on the financial committees in Congress is correlated with some unaccounted for or unobserved characteristics that increase a bank’s likelihood of receiving CPP funds but are unrelated to political influence. To address this possibility, we examine capital allocations to banks that were represented on congressional committees and Federal Reserve boards shortly before but not during the administration of CPP. We find that such former representation is not related to receiving CPP capital. This result mitigates the concern that our findings can be explained by unobservable bank attributes, at least to the extent they are persistent in the short term. Our findings also suggest that QFIs were more likely to receive an investment from CPP if they were bigger, had lower earnings, and had lower capital. This evidence is consistent with an investment strategy