Do election cycles, political stability, and government effectiveness matter for the risk of banks? Evidence from Indian banks

Abstract

We examine whether parliamentary elections, political stability, and government effectiveness affect banks’ risk in one of the largest democracies – India. We employ four measures of bank risk – net and gross Non-Performing Loans (NPL), the extent of loans restructured, and lending to the priority sector. Using dynamic panel data with a two-step system GMM approach, we find that NPL and lending to the priority sector increase during the years parliamentary elections are held. A stable political environment reduces net NPL, while an effective government increases NPL and lending to the priority sector. Further, we document meaningful differences in the behavior of state-owned and private banks around parliamentary elections. Credit market competition and moral hazard channels drive the relationship between bank risk and elections.