Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Benefits of Branching Deregulation

Academic journal article Federal Reserve Bank of New York Economic Policy Review

The Benefits of Branching Deregulation

Article excerpt

The Riegle-Neal Interstate Banking and Branching Efficiency Act, implemented in June 1997, enables banks to establish branches and buy other banks across the country. This legislation is the final stage of a quarter-century-long effort to relax geographic limits on banks. As recently as 1975, no state allowed out-of-state bank holding companies (BHCs) to buy in-state banks, and only fourteen states permitted statewide branching. By 1990, all states but Hawaii allowed out-of-state BHCs to buy in-state banks, and all but three states allowed statewide branching. The Riegle-Neal Act removes the remaining restrictions by permitting banks and BHCs to cross state lines freely.(1)

Although the effects of the recent federal legislation will be known only over time, we can study the impact of geographic restrictions on the banking industry by examining an earlier stage of the deregulatory process. The states were most active in removing geographic limits on banks in the fifteen years from 1978 to 1992. By observing the changes in banking that followed the state initiatives, we can learn much about the impact of these limits.(2) Previous research has suggested that geographic restrictions destabilized the banking system by creating small, poorly diversified banks that were vulnerable to bank runs and portfolio shocks (Calomiris 1993). In this article, we focus instead on the effect of the restrictions on the efficiency of the banking system.

We find that bank efficiency improved greatly once branching restrictions were lifted. Loan losses and operating costs fell sharply, and the reduction in banks' costs was largely passed along to bank borrowers in the form of lower loan rates. The relaxation of state limits on inter-state banking was also followed by improvements in bank performance, but the gains were smaller and the evidence of a causal relationship less robust.

Our analysis suggests that much of the efficiency improvement brought about by branching was attributable to a selection process whereby better performing banks expanded at the expense of poorer performers. It appears that the branching restrictions acted as a ceiling on the size of well-managed banks, preventing their expansion and retarding a process of industry evolution in which less efficient firms routinely lose ground to more efficient ones.

While the improvements to the banking system following deregulation helped bank customers directly, we also find important benefits to the rest of the economy. In particular, state economies grew significantly faster once branching was allowed--in part, we suggest, because deregulation permitted the expansion of those banks that were best able to route savings to the most productive uses. Although it is uncertain whether the observed acceleration in economic growth will last beyond ten years, the stimulative effect of branching deregulation on the economy has been considerable.


States began imposing limits on branch office locations in the nineteenth century. Such limits were intended in part to prevent unscrupulous bankers from "choosing inaccessible office sites to deter customers from redeeming . . . circulating banknotes" (Kane 1996, p. 142). Geographic limits were also justified by the political argument that allowing banks to expand their operations freely could lead to an excessive concentration of financial power. Appearing before Congress in 1939, the Secretary of the Independent Bankers Association warned that branch banking would "destroy a banking system that is distinctively American and replace it with a foreign system . . . a system that is monopolistic, undemocratic and with tinges of fascism" (Chapman and Westerfield 1942, p. 238).

Inefficient banks probably supported these restrictions because they prevented competition from other banks. Economides, Hubbard, and Palia (1995) show that states with many weakly capitalized small banks favored the 1927 McFadden Act, which gave states the authority to regulate national banks' branching powers. …

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