The Effects of Political Connections on Finance and Banking IRWAN TRINUGROHO SBM ITB FEBRUARY 9, 2016

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 Connections with Members of Parliament (e.g. Lord Browne of Maddingley, a member of the British House of Lords, is the CEO of British Petroleum)  Connections with a Minister or Head of State (e.g. Italy's Prime Minister Silvio Berlusconi is a large shareholder of four Italian listed firms: Arnoldo Mondadori Editore, Mediaset, Mediolanum, and Stand)  Companies Closely Related to a Top Official (e.g. members of the UMNO party in Malaysia) Political Influences on Business: Anecdotal Evidence Worldwide (Faccio, AER, 2006)

 The rent seeking theory (Krueger, 1974)  The grabbing hand theory (Shleifer and Vishny, 1994, 1998)  Politically connected firms Political Influences on Business

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 Routes of engagement: politicians initiate corporate, or corporate offers some stake to politicians  Form of connection: control devices (ownership, involvement in management and on the board) and political campaign contribution Routes and Forms of political connections

 Easier access to financial resources (Charumilind et al., 2006; Claessens et al., 2008; Fraser et al., 2006; Khwaja and Mian, 2005; Li et al., 2008)  Higher probability of being bailed out (Faccio et al., 2006)  Increase in firm value (Fisman, 2001; Goldman et al., 2009)  Build up confidence in the legal system (Li et al., 2008)  Improved performance (Johnson and Mitton, 2003)  Lower cost of equity capital (Boubakri et al., 2012)  Higher market power (Mobarak and Purbasari, 2006, Trinugroho, 2016)  Perceived less risky (Nys et al., 2015) Benefits of political connections

 Lower quality of accounting information reported (Chaney et al., 2011)  Lower qualifications of appointed managers and directors (Boubakri et al., 2012; Leuz and Oberholzer- Gee, 2006)  Decrease in long term performance (Claessens et al., 2008; Fan et al., 2007)  Higher cost of debt (Bliss and Gul, 2012)  Increasing audit fees (Gul, 2006; Wahab et al., 2009) Disadvantages of being politically connected

 Estimating the value of political connections (Fisman, AER, 2001)  Political connections, bank deposits, and formal deposit insurance (Nys, Tarazi, Trinugroho, JFS, 2015)  Politically Connected Banks: Some Indonesian Evidence (Sutopo & Trinugroho, EB Forthcoming 2016)  Political Connections and Market Power: Evidence from Indonesia (Trinugroho, working paper 2016) Political Connections in Indonesia: Some Empirical Evidence

 How much do connections matter?  To measure the value of connections, Fisman uses a string of rumors about former Indonesian President Suharto's health during his final years in office  In every case, the returns of shares of politically dependent firms were considerably lower than the returns of less-dependent firms  Well-connected firms will suffer more, relative to less-connected firms, in reaction to a more serious rumor Estimating the value of political connections

 The impact of banks’ political connections on their ability to collect deposits under two different deposit insurance regimes (blanket guarantee and limited guarantee)  Politically connected banks are able to attract deposits more easily than their non-connected counterparts, after the implementation of formal deposit insurance with limited coverage  Formal deposit insurance might have improved market discipline, but it has also exacerbated the issue of political connections in the banking sector Political connections, bank deposits, and formal deposit insurance

Expected SignModel Supply eq. Deman d eq. Supply (Dep. Variable: LNDEP) Demand (Dep. Variable: INTDEP) SupplyDemand Constant 12.82***1.213**12.83***1.169*** (0.000) LNDEP *** *** (0.000) INTDEP *** * (0.000) (0.070) SBPOL *** 1.341*** (0.000) PBPOL *** 0.681*** (0.000) LG+/ *** (0.000) SBPOL*LG *** (0.000) PBPOL*LG *** (0.000)

 The impact of being politically connected on bank performance and cost of funding  Political connections improve bank performance  Also, politically connected banks are benefited by getting a lower cost of funding  Political connections are less valuable for foreign banks Politically Connected Banks: Some Indonesian Evidence

Return on AssetsReturn on EquityInterest on Deposits Political Connections1.013***9.707***-1.841*** (0.000) State-owned Banks1.554***16.363*** *** (0.000) Private Politically Connected Banks0.703***5.885*** *** (0.000) Diversification0.031***0.030***0.239***0.216*** (0.000) (0.956)(0.818) Lerner Index0.473***0.409***4.765***3.981*** (0.000)(0.001)(0.000) (0.658)(0.874) Equity to Total Assets0.109***0.117***-0.229*** * (0.000) (0.002)(0.132)(0.267)(0.097) Net Interest Margins0.077***0.047*0.453*** **0.147*** (0.000)(0.055)(0.006)(0.686)(0.012)(0.000) Listed Banks-0.882***-0.594***-7.099***-3.546*** ** (0.000) (0.182)(0.018) Foreign Banks **-4.652*** (0.231)(0,016)(0.003)(0,133)(0.319)(0.174) Constant ***10.455***7.523***7.521*** (0.212)(0.193)(0.000)

ROAROEINTDEP State-owned Banks1.724***17.605***-2.658*** (0.000) Private Politically Connected Banks (PBCON)0.955***7.720***-1.205*** (0.000) PBCON*FOB-1.314***-9.568*** (0.002)(0.000)(0.461) Diversification0.028***0.199***0.004 (0.000) (0.866) Lerner Index0.404***3.942*** (0.001)(0.000)(0.864) Equity to Total Assets0.122*** (0.000)(0.297)(0.136) Net Interest Margins *** (0.120)(0.923)(0.000) Listed Banks-0.623***-3.753***-1.066** (0.000) (0.016) Foreign Banks (FOB)0.792*** (0,001)(0,973)(0.277) Constant-0.392*9.665***7.479*** (0.069)(0.000)

 The impact of political connections on market power  Market power is the ability of a firm to influence the price of products which can be measured using Lerner Index  Political connections might provide “privileges” for firms, preventing them from competition and creating industry barrier to entry Political Connections and Market Power: Evidence from Indonesia

Lerner Index (Market Power) Model 1Model 2 Political Connections0.305***0.133 (0.086)(0.252) CAR0.002 (0.002) LNTA0.054***0.052*** (0.007)(0.015) FOB0.203***0.207*** (0.036)(0.072) LISTED-0.211**-0.202*** (0.09)(0.06) HHI (0.024) POLCON_HHI0.02 (0.029) Constant Included

 Politics remarkably influences finance and banking at the micro level particularly in countries with high level of corruption, weak legal systems and poor governance (Faccio, 2006)  Politically connected firms may be benefitted of their connections in the short term (improve performance, higher probability of being bailed out, access to funding with a lower cost …..)  However, it may harm the society as a whole. It could also be a detrimental factor for well-distributed economic growth. Concluding remarks

 How do politicians extract resources from IPOs of government-controlled firms?  Political cycle and lending of state-owned banks: The power of incumbency  Do state-owned banks prefer to channel loans to politically connected firms?  ………………………………… Future Research Agenda

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