The Political Economy of Decentralization: Evidence from Bank Bailouts

Bian, B, Haselmann, R, Kick, T and Vig, V (2020) The Political Economy of Decentralization: Evidence from Bank Bailouts. Working Paper. Working Paper.

Abstract

In this paper, we examine whether decentralized decision making results in more efficient economic outcomes. In the German savings bank sector, distress events can be resolved either by a decentralized county-level politician or by a centralized state-level association. We document that decisions taken by the politicians at the decentralized level are distorted by personal considerations. While the occurrence of distress is not related to the electoral cycle, the probability of local politicians injecting taxpayers’ money into a bank in distress is 30 percent lower in the year directly preceding an election. Using the timing of the distress event in the electoral cycle as an instrument for who bails out the distressed bank, we show that decentralized bailouts result in inferior economic outcomes. These bailed-out banks perform more poorly and provision credit less efficiently when compared with more central-ized bailouts. We also observe a significantly worse real sector performance of localities that have undergone decentralized bailouts. Overall, our results highlight the political economy of decentralization – local politicians derive private benefits from controlling the bank at the expense of citizens at large.