U.S. POLITICAL CORRUPTION AND LOAN PRICING

• Published date: 01 August 2020
• Date: 01 August 2020
• Author: Lawrence Kryzanowski,Xiao Bing Ma,Ashrafee Tanvir Hossain
• DOI: http://doi.org/10.1111/jfir.12217

The Journal of Financial Research Vol. XLIII, No. 3 Pages 459–489 Fall 2020

DOI: 10.1111/jfir.12217

U.S. POLITICAL CORRUPTION AND LOAN PRICING

Ashrafee Tanvir Hossain

Memorial University of Newfoundland

Lawrence Kryzanowski

Concordia University

Xiao Bing Ma

Queen’s University

Abstract

Using U.S. Department of Justice data on state‐level political corruption, we find that

banks charge higher loan spreads (all‐in‐drawn spreads) to firms in states with higher

corruption and that these effects are more pronounced for firms facing financial

constraints but less pronounced for firms experiencing greater external monitoring.

These results are robust to additional controls, alternative corruption measures, a

measure of the lack of oversight of lobbyist activities, and the use of instrumental

variables. Overall, our findings are consistent with the harmful corruption environment

hypothesis, which states that banks charge higher loan spreads to firms in states with

greater political corruption environments as these firms are susceptible to making

suboptimal financial decisions to fend off rent‐seeking behavior.

JEL Classification: G10; G21; G32

I. Introduction

Political corruption has existed since the beginning of politics. As society evolved and

the rule of law was established, political corruption has become more polished and

sophisticated. Based on World Bank Enterprise Surveys (http://www.enterprisesurveys.

org/data/exploretopics/corruption), one in five companies worldwide receives at least one

request for a bribe payment, and almost one in three is expected to gift to secure

government contracts. Rent‐seeking behavior by corrupt politicians and government

officials from firms can be costly. In a recent study, Smith (2016) finds that firms deviate

from optimal financial policies to fend off rent seeking by corrupted officials.

We thank the editor and an anonymous reviewer for their thorough review and helpful comments and

suggestions, which significantly improved the quality of this paper. We also thank Beth Baugh for her excellent

copyediting. Hossain thanks Memorial University of Newfoundland for providing financial support for this

project (Account No. 209392, 212133). Kryzanowski thanks the Senior Concordia University Research Chair in

Finance and the Social Sciences and Humanities Research Council of Canada (SSHRC, Grant No. 435‐2018‐

048) for providing financial support. All remaining errors are our own. Compliance with Ethical Standards:

Hossain declares that he has no conflict of interest. Kryzanowski declares that he has no conflict of interest. Ma

declares that he has no conflict of interest.

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© 2020 The Southern Finance Association and the Southwestern Finance Association

We have much to learn about how localized political corruption affects

borrowing by firms. Bank loans are one of the major sources of capital for corporations

in the United States and globally. Banks are known to be careful about whom they lend

to, the terms of their loans, and the spreads they charge borrowers. We argue that it is

important to know how banks view corruption at a local level because of their large

effects on corporate financing policies. On the one hand, if banks view corruption as a

negative net cost for borrowers and charge higher loan spreads in corrupt regimes,

firms bear an additional cost in addition to the deviation from their optimal financial

policies (Smith 2016). On the other hand, if banks view corruption as being net

positive, we expect to observe lower loan spreads for firms in corrupt regimes. Given

that this important issue has not been investigated, our primary objective is to study the

relation between corruption at the U.S. state level and loan pricing (loan spreads) for

corporate America.

To address this gap in the literature, we develop two competing hypotheses

about the relation between loan pricing and the local corruption environment at the state

level. Evidence suggests that political connections, which need not be associated with

corruption, are beneficial for firms (e.g., Faccio 2006; Faccio, Masulis, and McConnell

2006; Goldman, Rocholl, and So 2009; Borisov, Goldman, and Gupta 2016). Lenders

offer higher leverage to firms with connections (Chiu and Joh 2004; Cull and Xu 2005;

Faccio, 2006; Khwaja and Mian 2005) as lenders anticipate that such firms will receive

support such as bailouts in times of financial distress (Faccio, Masulis, and McConnell

2006). Furthermore, Houston et al. (2014) find that banks charge lower loan spreads to

connected firms as connections enhance creditworthiness and passive monitoring from

political officials. It follows thatlocal political corruption, which is a much stronger form

of political connections, may play a similar role in setting loan spreads. This leads to the

conjecture that banks charge lower loan spreads to firms in more corrupt states based on

the expectation that such firms will use the local corruption environment in their favor

and perform better during times of financial stress. We refer to this conjecture as the

“beneficial corruption environment hypothesis.”

1

In contrast, there is evidence that corruption could be detrimental to firms.

Dass, Nanda, and Xiao (2016) find that state‐level corruption has a negative impact on

firm value. They find that firms located in different states but close to state borders are

affected by differences in state‐level corruption, which indicates that legal jurisdictions

matter despite similar local conditions. Firms in corrupt states often take questionable

steps to avoid rent seeking; for example, they may practice more opaque disclosure

policies (Stulz 2005; Durnev and Fauver 2011). Smith (2016) finds evidence in favor

of the shielding hypothesis. He reports that firms in more corrupt areas hold less cash

1

The beneficial corruption environment hypothesis is a less restrictive form of the political connections

hypothesis tested in the literature (e.g., Du, Tang, and Young 2012; Li, Song, and Wu 2015; Francis et al. 2016;

Bertrand et al. 2018; Chen et al. 2018) using various proxies for political connections such as previous

government experience of firm executives, political contributions, or nonzero government ownership. We are

interested in the environment in which corruption can flourish. We hypothesize that in a corrupt environment,

favors can be bestowed and/or solicited ex ante or ex post and need not be continuous via lobbying and other

efforts to minimize detection or possible conviction if detected.

460 The Journal of Financial Research