The aftermath of the financial crisis revealed failures and gaps in regulatory actions. In particular, regulators have been criticized for serving special interests—not only of the banks they regulate but also their own—rather than the interests of the general public. The resolution of failed banks in the United States is an important case in point. The Federal Deposit Insurance Corporation (FDIC) is tasked with efficiently handle bank failures and, to enable it to do so, is empowered to act independently, without interference from other agencies or courts, and to use its own discretion. This raises, however, potential concerns about transparency and the fairness of the resolution process.
In a recent paper (available here) we study whether special interests, through lobbying by banks, may compromise, or enhance, the efficiency of bank resolution carried out by the FDIC. Lobbying may introduce private interests into the decision-making process and distort regulatory actions through influence. But it can also provide the FDIC with useful private information, making the resolution process more efficient. The FDIC routinely auctions failed banks to interested bidders. In an efficient resolution process, this should result in ownership being transferred to the bidders that are best equipped to incorporate the new entity and place the highest valuation on it. At the same time, the sale should result in low resolution costs as stipulated by the ‘least-cost’ test that requires the FDIC to seek solutions that minimize the burden on the FDIC insurance fund.
Our analysis is based on information from virtually all failed-bank auctions during the financial crisis and its aftermath. We first provide clear evidence that bidding banks engaged in lobbying activities are in a better position to win an auction. Bidders lobbying banking regulators and, in particular, the FDIC at the time of the failure increase their probability of winning an auction by about 26 percentage points.
Moreover, we study whether lobbying also affects the costs associated with bank failure. For this, we compare the actual resolution costs to the costs that the FDIC would have incurred if another bid had been chosen. We show that the cost differential is significantly reduced, and is also more likely to be negative, when acquirers lobby. Lobbying acquirers thus seem to pay less than other bidders. The implied cost to the FDIC insurance fund is estimated at 16.4 percent of the total resolution losses, representing a total transfer from the insurance fund to lobbying bidders of $7.4 billion.
Besides the auction outcome itself, we further examine the post-acquisition performance of acquirers. We show evidence consistent with the expectation that the acquisition of a failed bank improves efficiency. However, we find that lobbying acquirers have substantially inferior efficiency outcomes relative to their non-lobbying counterparts. We also study the stock market reaction of the bidders surrounding the failed-bank acquisition announcement and find results consistent with lower efficiency for lobbying acquirers.
Importantly, our results speak to the channel through which special interests affect regulatory outcomes. In principle, there can be two opposing forces: lobbying can be conducted to obtain favourable treatment or to reveal useful information to regulators. The fact that lobbying allows banks to acquire other banks at lower prices suggests an economic misallocation, as this may prevent the bank with the highest valuation from winning the auction. Our auction results are also consistent with an informational channel: regulators allocate banks at lower prices to bidders who have conveyed private information that convince the regulators that they are better suited to incorporate the acquired bank. However, the fact that lobbying banks underperform relative to other acquirers appears inconsistent with such an efficiency-improving role of bank lobbying. Instead, it is consistent with agency-type inefficiencies in the allocation of failed banks, predicted by rent-seeking theories.
Taken together, our work suggests that, in the context of bank resolution, regulatory discretion may have costs by providing an opening for special interests to influence the process. This, by no means, implies that giving regulators discretion is undesirable—the ability to incorporate private information and to react to new circumstances in a speedy manner provides important benefits for financial stability. Rather, the resolution process should be designed to mitigate these costs by ensuring proper checks and balances. This includes establishing strong accountability mechanisms and a high level of transparency. In this context, our findings are relevant not only for the United States—where a framework for resolution of smaller banks is relatively well established and that for resolution of systemically important financial institutions has recently been reformed—but also in Europe where the implementation of new comprehensive resolution frameworks is currently in progress (see e.g. the fourth Special Report in the Geneva Reports on the World Economy here).
Deniz Igan is the Deputy Chief in the Research Department’s Macro-Financial Division at International Monetary Fund, Thomas Lambert is Assistant Professor of Finance at Rotterdam School of Management, Erasmus University, Wolf Wagner is Professor of Finance at Rotterdam School of Management, Erasmus University and Research Fellow at CEPR and Quxian Zhang is Assistant Professor of Finance at Monash Business School, Monash University.