Academic journal article Review - Federal Reserve Bank of St. Louis

The Real Effects of U.S. Banking Deregulation Commentary

Academic journal article Review - Federal Reserve Bank of St. Louis

The Real Effects of U.S. Banking Deregulation Commentary

Article excerpt

In the 1970s, commercial banks in the United States faced restrictions on interest rates, both on the deposit and lending sides of their business. They were restricted for the most part to classic financial intermediation-deposit-taking and lending-to the exclusion, for example, of underwriting many corporate securities and insurance products. And banks were limited in the geographical scope of their operations. No state permitted banks headquartered in other states either to open branches or to buy their banks, and many states prohibited or restricted intrastate branching.

Today, almost all of these restrictions have been lifted: Interest rate ceilings on deposits were phased out in the early 1980s; state usury laws have been weakened because banks may now lend anywhere; and limits to banks' ability to engage in other financial activities have been almost completely eliminated, as have restrictions on the geographical scope of banking. As a result, our banking system is now more competitive and more consolidated than everboth vertically and horizontally.

This paper focuses on how one dimension of this broad-based deregulation-the removal of limits on bank entry and expansion-affected economic performance. In a nutshell, the results suggest that this regulatory change was followed by better performance of the real economy. State economies grew faster and had higher rates of new business formation after this deregulation. At the same time, macroeconomic stability improved. By opening up markets and allowing the banking system to integrate across the nation, deregulation made local economies less sensitive to the fortunes of their local banks.

First, I explain how relaxation of geographical restrictions on bank expansion proceeded historically and why our somewhat unusual history of state-level regulation and deregulation presents an attractive setting to study how the financial system affects the real economy. I then present evidence ' that banking deregulation led to substantial and beneficial real effects on our economy. The findings are important for at least two reasons. First, they demonstrate the tight link between "Wall Street" and "Main Street." Finance is not only affected by the fortunes of the industrial sector, but the reverse holds true as well. This mutual dependence highlights the importance of financial regulation not only here in the United States but, perhaps even more critically, in emerging economies without a well-developed set of financial markets and institutions. Second, the results support the idea that competition and openness in financial markets are beneficial. This finding is accepted when applied to industrial firms-for most economists, free trade and competition are akin to motherhood-but it is much less accepted when applied to the financial sector.

BANK DEREGULATION AS AN EMPIRICAL LABORATORY

The evolutionary history of banking regulations in the United States offers researchers a unique opportunity to study the effects of deregulation, particularly those related to restrictions on banks' ability to expand within and across state lines, because regulations were imposed at the state level and because states changed their regulatory restrictions on expansion at different times. Although there was some deregulation of branching restrictions in the 1930s, most states continued to enforce these policies into the 1970s. In 1970, only 12 states allowed unrestricted statewide branching. Between 1970 and 1994, however, 38 states deregulated their restrictions on branching.1

In addition to branching limitations within a state, until the 1980s states effectively prohibited cross-state ownership of banks by applying the Douglas Amendment to the 1956 Bank Holding Company (BHC) Act. This amendment prohibited a BHC from acquiring banks outside the state where it was headquartered unless the target bank's state permitted such acquisitions. Since states chose to bar such transactions, the amendment effectively prevented interstate banking. …

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