Subsidized Coordination and Political Bargaining for Bail-Outs

Abstract

Can banks exploit the political economy to generate revenue? If bank creditors (local depositors) are voters, the bank's capital structure can act as a tool to impact the electorate and thus bail-outs by changing the relative group size of voters who favor as opposed to object bailouts. As the bank relies more on deposit financing, then given a firm failure, the politician grants larger bailouts due to economic voting. Ex ante, this generates a deposit insurance effect that alters the bank's optimal capital structure problem. The creditors' anticipation of high bailouts, allows the bank to reduce funding costs today, thereby increasing revenue. The bank, therefore, faces a trade-off: Classically, more creditors increase the bank's likelihood of failure but given failure, bailouts are larger due to economic voting. Bank funding costs become non-monotone in debt. Depending on the lenience ('influencing') with which non-creditor voters punish the politician when granting bailouts, funding costs can monotonically decline in deposit financing, allowing the bank to set maximally high debt ratio while maintaining voluntary participation of her depositors in a setting where no explicit deposit insurance exists.