Change-Point Analysis of the Growth Effects of State Banking Deregulation

By Freeman, Donald G. | Economic Inquiry, July 2005 | Go to article overview

Change-Point Analysis of the Growth Effects of State Banking Deregulation


Freeman, Donald G., Economic Inquiry


I. INTRODUCTION

Though most researchers agree that a healthy financial sector and robust economic growth go hand in hand, there remains some debate as to whether one is necessarily precedent to the other. One view, often identified with Schumpeter (1934), is that an efficient banking sector serves as the engine of growth by identifying and channeling financial capital to innovative entrepreneurs: financial development leads growth. The other view, as expressed by Robinson (1952), is that economic growth creates the conditions necessary for profitable financial intermediation: Growth leads financial development.

Goldsmith (1969) and McKinnon (1973) provide empirical evidence that high-growth economies tend to have well-developed financial markets, but issues of cause and effect are not addressed. More recent research, as summarized by Levine (2003), finds consistent results that countries with well-developed financial markets and institutions tend to grow faster than countries without and that financial developments tend to precede economic developments.

In the United States, the banking industry at the national level has undergone a series of major deregulatory moves over the past quarter century, beginning with the removal of some interest rate ceilings on deposits in 1978, followed closely by the Depository Institutions Deregulation and Monetary Control Act of 1980, running through the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, and culminating in the Gramm-Leaeh-Bliley Act of 1999, which overturns most of the provisions of the Glass-Steagall Act of 1933 and allows banks to affiliate with securities and insurance firms.

Proponents of deregulation argue that reform will have positive real growth effects by enhancing bank efficiency and allowing better geographic and sectoral diversification of bank portfolios. If these arguments bear out, the many reforms of the past few decades should result in higher overall growth for the U.S. economy. Opponents express concerns

that removing restrictions will limit competition, drive up the prices of banking services, and reduce accessibility as banks move away from less profitable lines of business and less desirable geographic regions. If these arguments bear out, the banking industry may benefit from deregulation, but the deadweight loss from increased monopoly power will reduce total welfare.

The difficulty in ascertaining which argument is correct is in isolating the effects of national bank deregulation among the many influences on aggregate economic growth. The U.S. economy is probably too large and complex to be measurably affected by incremental developments in a single sector. As an alternative, some researchers have taken advantage of the state-chartering provisions of banking in the United States and the historical restrictions on interstate banking to focus on the effects of bank deregulation on economic growth at the state level. Because the states removed restrictions, especially those governing bank branching, at different times, a correlation of dates of changes in state growth rates with the dates of deregulation holds the possibility of identifying growth effects of bank deregulation.

For branching deregulation as a specific reform, papers by Jayaratne and Strahan (1996), Krol and Svorny (1996), and Strahan (2003), using fixed effects regressions of state panels of economic growth, find positive intercept shifts for states subsequent to years of deregulation. The effects of branch deregulation are found to be quite considerable, to the order of a permanent 0.5% increase in annual real state growth, or about $40 billion in additional income per year at current rates for the 37 states that have deregulated since 1970.

The difficulty in these types of exercises, however, is in separating the change in regulation from the existing economic environment. The 1980s, when many reforms were enacted, was a time of acute economic stress for many states, when banks and other financial institutions were struggling with bad loans in real estate and commodity sectors, and buyers were sought for the assets of failed institutions. …

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