Political connections and banks' credit smoothing behavior: Incentives and costs

This paper looks into the black box of banks' credit smoothing behavior. Using a sample of 128 Chinese banks over the period of 2007–2014, we identify politically connected banks by the government experience of their chairmen, and find that the lending behavior of politically connected non-state banks is less procyclical than their non-connected peers. In addition, there is no heterogeneity in the lending behavior of politically connected state banks versus their non-connected counterparts. The effect of political connection on loan interest rates indicates that the credit smoothing behavior is driven by the supply side. Further analyses regarding incentives rule out the lazy manager hypothesis and the better funding source hypothesis, and support the political rent-seeking hypothesis. The credit smoothing behavior causes the deterioration of the credit quality, and it is masked more in special-mention loans in addition to being reflected as a higher non-performing loans ratio, which may threaten the stability of the banking sector inconspicuously. The results suggest that regulators should scrutinize banks' political connections more thoroughly and pay more attention to the supervision of special-mention loans.