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Article Excerpt
In 1963, 13,291 U.S. banks operated 13,581 branches. By 1997, the number of banks fell to 9143 while the number of branches mushroomed to 60,320 (Radecki 1998). Changes in geographic banking markets arising from bank deregulation led to tremendous growth in branch networks. Consequently, understanding the effects of bank deregulation on economic performance (e.g., within a state) has gained increasing importance, particularly over the last decade as bank consolidations reached record numbers and unit banking approached extinction. The Riegle-Neal Act of 1994 permitted interstate banking and branching and undoubtedly escalated consolidation in banking.
The connection between the financial services sector and economic performance emerged in the finance and economics literature as early as the beginning of the 20th century. For example, Schumpeter (1911) argued that services offered by financial intermediaries are essential for technological innovation and economic development. In contrast, the theoretic view of Robinson (1952) and Solow (1956) was that financial intermediation had only minor effects on economic growth. In recent theoretical research, Bencivenga and Smith (1991) focus on the concept that savings behavior will generally influence equilibrium growth rates through the activities of intermediaries that promote capital investment and, therefore, tend to increase rates of growth. Greenwood and Jovanovic (1990) link financial systems and economic growth via an endogenous model that specifies that financial intermediation fosters higher rates of return earned on capital and thereby promotes growth. King and Levine (1993b) focus on the endogenous determination of productivity-driven growth, which is taken to be the result of rational investment decisions by profit-maximizing entrepreneurs.
On the empirical side, researchers have found evidence supporting the hypothesis that a range of financial indicators are positively correlated with economic growth. McKinnon (1973) and Shaw (1973) provide evidence that high growth economies tend to have well developed financial markets. More recently, King and Levine (1993a) and Levine and Zervos (1993) in cross-country studies found that higher levels of financial development are positively correlated with economic development. Levine's (1998) findings suggest that the legal environment facing banks can have a significant impact on economic growth through its effect on bank behavior. Rajan and Zingales (1998) find that in a large sample of countries, financial development facilitates economic growth by reducing the costs of external finance to firms. (1)
In another recent study, Jayaratne and Strahan (1996; hereafter J&S) suggest that the geographic structure of banks and bank holding companies may play a major role in affecting economic growth. Liang and Rhoades (1991), measuring the performance of banks following geographic banking deregulation, reveal that larger BHCs can take advantage of wide branch networks to more effectively diversify loan portfolios. Diversified portfolios appear to improve bank performance by increasing the quality of the loan portfolio, which, in turn, lowers risk. Increasing geographic or depositor diversification with larger branch networks improves operational efficiency by moving inefficient institutions closer to their efficiency frontier (Hughes et al. 1996). They also found evidence of large economies of scale that increase with bank size (under $3 million to over $50 billion in assets) and with geographic expansion. Other studies find scale efficiencies for small (up to $500 million in assets) banking organizations resulting from wide branch networks (Berger and Humphrey, 1991, McAllister and McManus, 1993).
Financial innovations (e.g., securitization and interest rate swaps) may play a crucial role in promoting market efficiency (Finnerty 1988) and thus short-run economic growth. Geographic expansion by banks may make lending more productive due to the gains in efficiency and increased product availability (e.g., insurance mutual funds, and variations on basic product lines). In addition, the liberalization of geographic banking and branching may improve financial intermediation by increasing the accessibility of banking services (Calem 1993). (2)
In summary, intra- and interstate banking and branching deregulation (hereafter, simply geographic deregulation) may result in improved financial market efficiency through diversification and improved loan portfolios, reductions in bank costs, product innovation, and increased service availability. Government policies that promote efficiency in the U.S. banking system and increase the level of investment should be given consideration because of their implications for growth and development. This investigation analyzes the effects of financial deregulation on economic growth by augmenting the work of J&S, who use a generalized "difference-in-differences" methodology with a fixed effects model. While this study largely follows the J&S approach, it differs in two important ways. First, it replaces the J&S dummy variable indicating liberalization of intrastate branching regulations with a continuous variable describing the extent of the banking market for a state's banks. This continuous variable captures the extent of a state's banking market after the passage of intrastate branching and interstate banking laws. Second, this study uses a two-stage model to determine whether banking deregulation promotes economic growth through its influence on the size of banking markets. The two-stage method is similar to the one used by Levine (1998) where variables (legal indicators) from the first stage are used as instrumental variables in the second stage to determine if banking development defined by the legal environment is positively related to economic growth. In comparison, I estimate the first stage of the model by projecting a proxy for the size of banking markets onto a set of regulator indicator variables. In the second stage, economic growth is projected onto a set of regressors: the predicted value of banking market size and the residual from the first-stage regression along with other control variables.
The main contribution of this paper is...
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