Political incentives and financial innovation : the strategic use of toxic loans by local governments

We investigate the development of an innovative and high-risk type of borrowing for local governments, known as structured loans. Using transaction data for more than 2,700 local governments in France, we show that the adoption of these instruments is more frequent for politicians from highly indebted local governments, from politically contested areas, and during political campaigns. Taking on structured loans helps incumbents get re-elected, and initially allows them to maintain lower taxes. Our findings illustrate how financial innovation can amplify principal-agent problems within the political system