The Political Economy of Financial Innovation: Evidence from Local Governments
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 the cost of 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.
Keywords: financial innovation;
Financing and Loans;
Innovation and Invention;