The Trouble with Government-Subsidized Banks

Alex Tabarrok links to a new paper examining the “political credit cycle” in India, where there are many state-owned banks:

This paper integrates theories of political budget cycles with theories of tactical electoral redistribution to test for political capture in a novel way. Studying banks in India, I find that government-owned bank lending tracks the electoral cycle, with agricultural credit increasing by 5–10 percentage points in an election year. There is significant cross-sectional targeting, with large increases in districts in which the election is particularly close. This targeting does not occur in non-election years, or in private bank lending. I show capture is costly: elections affect loan repayment, and election year credit booms do not measurably affect agricultural output.

Tabarrok asks “Need I explain the relevance?” To me, the relevance does merit some explication. The most immediate relevance is that I think this counts as a legitimate reason to be wary of the prospect of government-owned banks and therefore to make us skeptical about bank nationalization. But it’s important to understand that the reason nationalization is being discussed is that more mainstream debate keeps coming around to the idea of handing private banks a multi-trillion dollar subsidy. The contention isn’t that government-owned banks is a good idea. The contention is that nationalization is a better idea than the “free money for bank owners” plan. And note that this exact same problem of a political credit cycle would arise in a situation wherein banks are privately owned, but dependent on government subsidies to stay in business. Indeed, I would argue that subsidies probably pose a bigger danger.

When the Swedes nationalized their banks, they set up the state-owned entity Securum as a fairly independent agency with a clear mandate to maximize shareholder value. That mission — shareholder value — is precisely what would prevent a political credit cycle. But if privately owned banks are going to be financing their activity with public funds, it’s going to be extremely difficult to make the case that the banks deserve to be insulated from public pressure. Managers of a publicly owned bank who come under criticism for profit-maximizing behavior, can defend their independence by saying that their job is ultimately to earn back as much of the taxpayers’ money as possible. I’m not sure what a privately owned, publicly funded bank could say on its own behalf.


Again, this isn’t to deny that bank nationalization is problematic. It’s very problematic and we ought to act swiftly to reprivatize any nationalized banks. But across a wide swathe of dimensions, it’s less problematic than the main alternative.