Download Deregulation of Bank Entry and Bank Failures

Deregulation of Bank Entry and Bank Failures∗
Krishnamurthy Subramanian
Indian School of Business
Ajay Yadav
Fuqua School of Business, Duke University†
May 13, 2012
Abstract
Does bank deregulation enhance bank stability or exacerbate bank fragility? Despite its importance, this question remains open since the theoretically predicted effect
of deregulation on bank stability is ambiguous. Using the deregulation of entry restrictions in the U.S. states, we show that deregulation enhances bank stability by lowering
bank failures. While intra-state deregulation lowers bank failures, inter-state deregulation, which led to the integration of banking systems in the U.S., has no effect. Bank
failures decreased primarily in the sixteen unit-banking states and stemmed from benefits created by portfolio diversification, operating efficiencies and reduced loan losses.
Mechanical effects due to mergers and acquisitions do not explain our results. Preexisting bank failures in a state did not determine its timing of deregulation, which
assures against reverse causal effects. As well, placebo effects do not account for our
results: the deregulation had no effect on thrift failures.
Keywords: Banks, Banking Crises, Bank Failure, Competition, Consolidation, Crisis, Deregulation, Entry
JEL Codes: G01, G21, G28, G33
∗
We would like to thank Phil Strahan for his inputs regarding the Garn-St. Germain Act of 1982 and
Viral Acharya, N Prabhala, Raghuram Rajan and Luigi Zingales for their valuable comments and suggestions.
Please address correspondence to Krishnamurthy Subramanian at [email protected].
Ajay Yadav would like to thank the Indian School of Business for research support. The usual disclaimers
apply.
†
Ph.D. (Finance) student at Fuqua School of Business, Duke University starting in Fall 2012
Deregulation of Bank Entry and Bank Failures
Abstract
Does bank deregulation enhance bank stability or exacerbate bank fragility? Despite its importance, this question remains open since the theoretically predicted effect
of deregulation on bank stability is ambiguous. Using the deregulation of entry restrictions in the U.S. states, we show that deregulation enhances bank stability by lowering
bank failures. While intra-state deregulation lowers bank failures, inter-state deregulation, which led to the integration of banking systems in the U.S., has no effect. Bank
failures decreased primarily in the sixteen unit-banking states and stemmed from benefits created by portfolio diversification, operating efficiencies and reduced loan losses.
Mechanical effects due to mergers and acquisitions do not explain our results. Preexisting bank failures in a state did not determine its timing of deregulation, which
assures against reverse causal effects. As well, placebo effects do not account for our
results: the deregulation had no effect on thrift failures.
Keywords: Banks, Banking Crises, Bank Failure, Competition, Consolidation, Crisis, Deregulation, Entry
JEL Codes: G01, G21, G28, G33
I
Introduction
The financial crisis of 2008 highlighted the debilitating effect that a disruption in the
banking sector can have on the macro-economy. More generally, bank failures impose significant economic costs (Friedman and Schwartz (1963), Bernanke (1983), Ongena et al.
(2003), Calomiris and Mason (2003), Ashcraft (2005), Dell’Ariccia et al. (2005), Reinhart
and Rogoff (2008), Iyer and Peydró (2010), Iyer and Puri (2011)). Not surprisingly, therefore, preserving banking sector stability has occupied center stage in regulatory and policy
making circles; the enactment of the Dodd-Frank Act of 2010 represents a case in point.
As well, deregulation in the banking sector is often blamed for bank failures (see Wilmarth,
2004 for example). In fact, many attribute blame for the recent financial crisis to financial
deregulation, including bank branch deregulation, the Gramm-Leach-Bliley Act, and the lax
regulatory approach of the Federal Reserve (see Moss, 2009 among others).1 In this context,
a question that is important to academics and policymakers alike is: does deregulation lead
to instability in the banking sector? In this paper, we examine the causal effect of bank
deregulation on bank failures.
Studying the effect of deregulation on bank failures (not just bank distress) is important.
First, the systemic risks resulting from contagion among banks manifest only after actual
bank failure (rather than just bank distress). As well, the adverse real effects mentioned
above are more pronounced after bank failure than bank distress. Despite its importance, the
effect on bank failures of competition engendered by deregulation remains an open question.
Theoretical models provide opposing predictions about the effect of bank deregulation on
the stability of banks. Some theoretical models argue that increased competition created by
deregulation renders banks more susceptible to failures. First, as theoretically modeled by
Marcus (1984), Greenbaum and Thakor (1986), Keeley (1990), Besanko and Thakor (1993),
Hellmann, Murdoch and Stiglitz (2000), and Matutes and Vives (2000), in concentrated
banking systems, banks may exercise greater market power and generate greater profits.
Since banks value their banking charter considerably in such environments, they may take
systematically lower risk and are more likely to survive. Second, banks earn fewer rents
in a more competitive environment, which may reduce their incentive to properly screen
borrowers, thereby enhancing the likelihood of bank failure (Allen and Gale (2000, 2004)
and Boot and Greenbaum (1993)).
In contrast, other theories contend that increased competition reduces bank failures.
First, Klein (1974), Hayek (1978, 1990) argue that competition among banks enhances effi1
Igan, Mishra, and Tressel (2011) and Igan and Mishra (2011) provide evidence that lobbying by the
financial industry played a role in “making the regulatory environment lax, which allowed the lenders to
engage in riskier lending.”
1
ciencies, strengthens the banking system and thereby decreases bank failures. Second, after
deregulation, banks can diversify their assets across different geographies and thereby limit
their risks (Gart (1994), Hubbard (1994)). Finally, Boyd and De Nicolo (2005) contend that
since borrowers respond endogenously to the high interest rates charged by monopolistic
banks, borrowers would assume greater risks, thereby endangering monopolistic banks. As
well, competition among banks forces managers to improve the quality of loans by improving
screening and monitoring and avoiding less productive loans (Jayaratne and Strahan, 1996).
In light of these contrasting predictions, we evaluate whether deregulation that led to greater
competition among banks increased, decreased, or had no effect on bank failures.
Specifically, we exploit the deregulation of bank entry across the U.S. states since the
1970s to investigate its effect on bank failures. Given the staggered manner in which deregulation occurred, we can use states that have not deregulated till a particular point in time
as a control group to account for potentially confounding effects at the state level. We use
data on bank failures from FDIC’s Historical Statistics on Banking together with the data
on deposits and assets of banks from Bank Call Reports. We employ the proportion of all
banking sector deposits/assets lost due to bank failures in a state, year for the following reasons. First, unlike the total deposits/assets accounted for by failing banks, these normalized
measures have the advantage of not being affected by the expansion/contraction of the banking sector in a particular state. Second, unlike measures based on the number of failures,
these proxies account for the disproportionate adverse effects of large bank failures vis-à-vis
small bank failures. Finally, since the variable of interest, i.e. banking deregulation, varies
at the state level, state-level measures avoid econometric concerns stemming from spurious
variation due to bank-specific omitted factors.
State-level estimates of bank failures are reliable even after deregulation in our case. As
Bird and Knopf (2009) document, the proportion of banks that had branch offices in more
than one state was only 2.68% even in 1999 — five years after the enactment of the RiegleNeal Act that allowed nationwide banking. Since inter-state banking has been growing over
time and we end our sample in 1994 to coincide with the enactment of the Riegle-Neal Act,
few banks possessed inter-state banking operations during our sample period.
This paper’s main finding is that deregulation decreases bank failures, which is summarized in Figure 1. This figure shows the average year-on-year change in the deposits of
liquidated banks over a 25-year window surrounding the year of deregulation. The hollow
circles report the point estimates of the effect in a particular year relative to the year of
deregulation while the dashed lines represent 95% confidence intervals. It is quite clear from
figure 1 that the percentage of deposits lost due to bank failures decreased two years after
deregulation and persisted for a decade after deregulation.
2
Figure 1: Change in the deposits of liquidated banks before and after branch deregulation
In the econometric variant of this visual test, we examine the effect of the regulation
on future bank failures up to three years after deregulation as a difference-in-difference: the
difference in the proportion of deposits (and assets) lost due to bank failures in a state
before and after the deregulation, compared to the same difference for states that did not
undergo a deregulation during the same period. We estimate this effect in panel regressions
that include state and year fixed effects to control respectively for time-invariant unobserved
factors affecting bank failures at the state level as well as time trends. We also include
several lags of the growth of per capita GDP in the state. We find that bank failures are
negatively correlated with deregulation of bank entry. The economic effect is large: after
deregulation, the decrease in the proportion of deposits lost due to bank failures reduced
annually by 23.6% of its standard deviation. Furthermore, by examining the dynamic effects
of deregulation, we find that the effect is quick and does not die down with time.
The second key finding of the paper is that the nature of banking deregulation matters
with respect to their effect on bank failures. Intra-state deregulation, which enabled banks
to acquire branches/subsidiaries of other banks and merge their operations into their own,
decreases bank failures. In contrast, inter-state deregulation has no effect on bank failures.
Interstate deregulation allowed the banking system in the U.S. to integrate across state
lines. While the U.S. effectively had fifty small banking systems prior to deregulation (one
for each state), after inter-state deregulation, about 60 percent of a state’s banking assets
were owned by a multi-state banking company (Strahan, 2002). Naturally, it is expected
that the moral hazard induced by the “too big to fail” syndrome would manifest due to inter3
state deregulation. Our results suggest that at least using the bank failures till the period of
enactment of the Regal-Neil Act of 1994, such moral hazard did not seem to affect banking
sector fragility. These contrasting results are consistent with the effect of the regulation
being greater in environments where the structure of the banking market changed due to
deregulation. As Strahan (2002) explains, only intra-state deregulation had a significant
effect on the structure of the banking markets; inter-state deregulation had no effect.
A key alternative interpretation of our results is that they are a manifestation of the
mechanical effect of increased mergers and acquisitions (M&A) post deregulation. In particular, inefficient banks may have been acquired by better run banks resulting in a weeding
out of weak banks from the system. To examine this interpretation, we study separately
the effect of the deregulation on failures of small and large banks according to their size
compared to that of the median bank failure in a state, year. Since small banks are more
likely to merge or be acquired, the reduction in bank failures should have been greatest in
the small banks if the reduction were due to the mechanical effect of M&A. However, we
find that deregulation decreased bank failures uniformly for both categories, which contrasts
with this alternative explanation.
With respect to the channels through which deregulation reduced bank failures, our evidence together with those found by prior studies suggest three main sources. First, banks
benefited from greater portfolio diversification. Banking regulations led to instability by creating small banks that could not diversify easily, which made banks vulnerable to portfolio
shocks (Calomiris, 2000). After deregulation, banks could diversify their assets and thereby
limit their risks (Gart (1994), Hubbard (1994)). We test for the presence of diversification
benefits in two ways. First, if such diversification was indeed responsible for the observed
reduction in bank failures, then we should see a greater reduction in bank failures for unitbanking states. As banks in the unit banking states were allowed to open only one branch,
banks in these states were the least diversified. Therefore, by allowing banks to open new
branches, branching deregulation led to the greatest increase in diversification opportunities
for banks located in these states. Accordingly, we find that the reduction in bank failures
were restricted primarily to the sixteen unit-banking states. Second, as a direct test, we use a
measure of portfolio diversification across different sectors and find that not only did diversification increased significantly post-deregulation but also such increases were contributed
primarily by the unit banking states. These two results together lead us to conclude that
portfolio diversification provided a key benefit for banks post deregulation.
Second, banks became more efficient post-deregulation as better banks grew at the expense of their less efficient rivals. Jayaratne and Strahan (1998) find that operating costs
of banks decreased by about 8% after intra-state deregulation. Stiroh and Strahan (2003)
4
find that although better-performing banks grew faster than under-achievers before intrastate branching was allowed, low-cost, high-profit banks grew even faster once branching
restrictions were lifted. Furthermore, the lifting of restrictions on branching enabled banks
to exploit economies of scale. Our evidence that deregulation reduced failures for banks of
all size categories suggests that these efficiency gains were reaped by banks of all sizes.
Third, bank failures reduced due to lower loan losses suffered by banks. Given greater
competition following deregulation, most of the reduction in banks’ costs were passed along
to bank borrowers in the form of lower loan rates. Average loan rates fell by about 19 basis
points in the short run and by 30 basis points in the long run (Strahan, 2002). As Boyd and
De Nicolo (2005) argue, since borrowers respond endogenously to the interest rates charged
by banks, the lower interest rates charged may have reduced moral hazard by borrowers. As
well, competition among banks forced managers to improve the quality of loans by improving
screening and monitoring and avoiding less productive loans (Jayaratne and Strahan, 1996).
The decrease in loan losses by about 50% after intra-state branching deregulation, as pointed
out by Jayaratne and Strahan (1998), is consistent with these forces being at play.
We complete our analysis by investigating concerns relating to reverse causality and
omitted variable bias. To investigate possible reverse causality, we examine whether prior
bank failures in a given state help to predict the timing of deregulation in that state. While
we find that the political factors identified by Krozner and Strahan (1999) continue to predict
the timing of branching deregulation, bank failures have no explanatory power by themselves.
Our results could also be driven by omitted variables. For example, technological changes
that may have led to deregulation could also have led to the reduction in bank failures if such
technological changes enabled banks to screen/monitor borrowers better. To address such
concerns, we analyze possible placebo effects by examining the effect of bank deregulation
on failure of thrifts. Since the Garn-St. Germain Act of 1982 had permitted thrifts to
branch across state borders, bank deregulation did not affect the entry barriers faced by
thrifts. Furthermore, any economy-wide factors that may have affected bank failures would
affect failure of thrifts as well. Therefore, failure of thrifts represent a placebo effect in our
setting. We find that branching deregulation did not have any effect on thrift failures, which
mitigates concerns regarding omitted variable bias.
This paper relates to policy debates concerning the current financial crisis and the role
of regulation in promoting stability in the banking sector and thereby economic development. With economists and policymakers emphasizing the potential dangers of financial
deregulation in the light of the “Great Recession,” governments worldwide are re-assessing
their approaches to bank regulation. Though we do not directly examine the current crisis,
our results indicate that the dismantling of regulations that impeded competition among
5
banks added to the stability of the banking sector. Even inter-state deregulation, which
led to a more integrated banking sector in the U.S., did not exacerbate banking sector
fragility. Therefore, our results caution governments against imposing excessive regulation
in the banking sector.
The remainder of the paper is organized as follows. The next section reviews the literature. Section III presents background information and develops our hypotheses. Section IV
describes the data and proxies. Section V describes our empirical methodology and reports
the results. Section VI discusses the possible channels for the documented effect. Section
VIII concludes.
II
Review of Literature
We contribute to the literature examining the effect of the deregulation of bank entry on
bank stability. Our study differs from Jayaratne and Strahan (1998) and Stiroh and Strahan
(2003), who examine the effect of deregulation on bank performance, since we examine the
effect of banking deregulation on bank failures directly. While the decrease in loan losses
or the strengthening of the relationship between lagged bank performance and its market
share constitute the channels through which bank failures reduced failures post deregulation,
these proxies do not directly capture the risk of bank failures. For example, two banks with
similar quality of loan portfolios and magnitude of loan losses may be more or less likely to
fail depending on how well the bank is capitalized. In fact, Keeley (1990) finds that greater
competition among banks reduces bank capital. Consistent with this, we find evidence
that bank capital reduce post deregulation. If the effect of the reduction in bank capital
had dominated the effect of improvements in bank performance, banks failures may have
increased post-deregulation. As well, compared to proxies for bank distress, our focus on
bank failures incorporates the fact that the systemic risks from contagion manifest only after
bank failure (not just bank distress).
Our evidence contrasts with that of Keeley (1990), who argues that increased competition
decreases bank stability. Using data on bank holding companies and using a bank’s Tobin’s Q
as a measure of the bank’s market power, Keeley (1990) finds that the market-value-capitalto-assets ratio of a bank increases with the market power of the bank. Keeley interprets
this as evidence that increased competition decreases the bank’s charter value and thereby
increases the likelihood of bank failures. Our evidence contrasts with that of Keeley (1990)
for multiple reasons. First, we examine bank failures directly. Second, since a bank’s market
power may be endogenously related to unobserved bank characteristics, our study differs
from Keeley (1990) in attribute in a causal effect of changes in banks’ market power due to
deregulation on bank failures.
6
Our study also relates to work examining the effect of branching restrictions on bank failures during the Great Depression era. Studies using state- and county-level data find that
states allowing branching had lower failure rates (Mitchener 2005, Wheelock 1995). Studies
of individual banks find contrasting results. Calomiris and Mason (2003) and Carlson (2004)
find that branch banks were more likely to fail than other banks. In contrast, Carlson and
Mitchener (2009) find that unit-banks that had to compete with larger branching networks
improved their efficiency and profitabilty and were more likely to survive the Great Depression. Wheelock and Wilson (2000) use Kansas banks during the depression and find that
inefficient banks were more likely to fail than efficient banks.2 The deregulation of entry
restrictions by U.S. states in the 1980s comprised of intrastate and interstate deregulation,
on the one hand, and resulted simultaneously in greater competition in the local banking
markets as well as greater consolidation among banks at the state level, on the other hand
(Strahan, 2002). Therefore, the results obtained for the Great Depression era cannot be
extended to the deregulation of entry restrictions by U.S. states in the 1980s. Moreover, by
addressing concerns relating to reverse causality and omitted variable bias, we are able to
identify better the effect of the deregulation of bank entry on bank failures.
Other prior work examines the impact of removal of entry restrictions on other economic
outcomes. Jayaratne and Strahan (1996) analyze the impact of intra-state branching deregulation on economic growth and find that states grow faster after deregulation. Black and
Strahan (2002) and Kerr and Nanda (2009) explore the impact of these regulations on entrepreneurship: Black and Strahan (2002) find that the rate of new incorporations increases
after intra-state deregulation while Kerr and Nanda (2009) find that both new firm creation and churning among new firms increase following inter-state deregulation. Black and
Strahan (2001) document that the wage gap between male and female executives decreased
and women’s share of employment in managerial positions increased in the U.S. banking
sector following deregulation. Beck et. al. (2010) find that banking deregulation tightened
the distribution of income by boosting incomes in the lower part of the income distribution
while having little impact on incomes above the median. We contribute to this literature by
providing evidence of the effect of bank deregulation on bank failures.
This study also relates to the broader issue of regulation in the banking sector. Kroszner
and Rajan (1994) indicate that Glass-Steagal Act of 1933, which led to the separation of
commercial and investment banking, constrained the bank’s ability to underwrite high quality securities without providing any significant benefits. Also, Ramirez (1999) points out
that this regulation might have raised the costs of raising external funds for investment pur2
In international evidence, Beck, Demirguc-Kunt and Levine (2006) found that probability of crisis increases with increase in the fraction of applicants denied entry as a fraction of total applicant pool.
7
poses by the corporations. Aharony and Swary (1981) analyzed the impact of the 1970s
amendment to the Bank Holding Company Act that allowed banks to participate in the
non-banking activities. Their analysis suggests that the amendment had no effect on either
BHC’s risk or profitability. Demirguc-Kunt and Detragiache (2002) and Demirguc-Kunt and
Huizinga (2004) provide cross-country evidence on the adverse effects of deposit insurance.
They suggest that explicit deposit insurance lowers market discipline for risk taking and
increases the likelihood of banking crises. Our study similarly finds that deregulation of the
banking sector in the U.S. increases the stability of the banking sector.
III
III.A
Background and Empirical Hypotheses
Deregulation of Entry Restrictions by U.S. states
The banking sector in the U.S. has been highly regulated historically. Until the 1970s,
almost all states restricted within state branching, which meant that a bank cannot expand
within the state boundaries by opening new branches. In the 1970s and 1980s, most states
passed laws removing the restrictions on the ability of banks to open or acquire new branches.
Two classes of restrictions were eased over this period. First, intra-state deregulation allowed
banks to expand within the passing state either by acquiring other bank branches or by setting up new bank branches themselves. Second, inter-state branch banking deregulation
allowed banks to acquire branches in other states with which their ‘home state’ had negotiated such a bilateral agreement. Due to the reciprocal nature of these agreements, most
states undertook inter-state deregulation in the mid 1980s to early 1990s. Interstate deregulation allowed the banking system in the U.S. to integrate across state lines. While the
U.S. effectively had fifty small banking systems prior to deregulation (one for each state),
after inter-state deregulation, about 60 percent of a state’s banking assets were owned by
a multi-state banking company (Strahan, 2002). These state-level reforms culminated in
the Riegle-Neal inter-state Banking and Branching Efficiency Act of 1994, which allowed
national inter-state branch banking after 1995.
III.B
Deregulation of Entry and Banking Market Structure
The prior literature suggests that branching deregulation led to substantial changes in the
structure of banking markets. Consolidation occurred as large multibank holding companies
(MBHCs) acquired banks and converted existing subsidiaries into branches (McLaughlin,
1995). Between 1988 and 1997, both the number of banks and the number of banking
organizations fell by almost 30%. As a result, the share of total assets held nationwide
by the largest eight banking organizations rose from 22.3% to 35.5% (Berger, Demsetz and
8
Strahan, 1999). The share of banking assets held by banks with assets under $100 million decreased from 24% in mid-70s to 15% in the mid-90s. Despite the consolidation, the
Herfindahl-Hirschmann index of concentration in local markets has remained stable. As Strahan (2002) argues, this is reasonable because the restrictions on branching and inter-state
banking generally did not apply to local markets.
Among the two different forms of deregulation — intra-state and inter-state — the literature
argues that only intra-state deregulation had a significant effect on the structure of the
banking market. In contrast, banking structure did not change much after the inter-state
banking deregulation. For instance, Amel and Liang (1992) find significant entry into local
markets through de novo branching after the removal of intra-state branching restrictions.
However, they do not find much change after inter-state deregulation. Similarly, Jayaratne
and Strahan (1998) find that operating costs and loan losses decrease sharply after intrastate branching restrictions are lifted; however, the effects of the removal of inter-state branch
regulation are not strong.
III.C
Deregulation of Entry and Bank Failures
Theoretically, the effect of the deregulation of bank entry on bank failures is ambiguous.
Some studies argue that monopolistic banks earn more profits and reduce the chances of a
banking crisis by using these higher profits as “capital buffers” to be used at the time of some
negative macroeconomic shock. In monopolistic banking systems, bank charters are valuable
and these high charter values deter bank’s management from making risky investments as
failure could result in the loss of the valuable charter (see Marcus (1984), Greenbaum and
Thakor (1986), Keeley (1990), Besanko and Thakor (1993), Hellmann, Murdoch and Stiglitz
(2000), and Boyd et al. (2004)). We label this the bank charter channel.
However, there is a counterview that unregulated banking reduces bank fragility. Klein
(1974), Hayek (1978, 1990) argue that competition among banks enhances efficiencies, strengthens the banking system and thereby decreases bank failures. Along these lines, Stiroh and
Strahan (2003) find that increased competition forced bank managers to cut down costs, improve the quality of service and enhance efficiency. Those banks that failed to do so shrank
or exited the system and were replaced by strong banks, which strengthened the banking
system as a whole. These effects together constitute the efficiency channel through which
banking deregulation can reduce bank failures.
In a regulated environment, banks were forced to primarily lend to firms in the local
economy. Since firms in different geographies may specialize in different sectors, banks
could not diversify their assets across different sectors of the economy. Calomiris (2000)
suggests that banking regulations led to banking instability by creating small banks that
9
could not diversify easily, which made banks vulnerable to local macroeconomic downturns
and portfolio shocks. In contrast, after deregulation, banks could diversify their assets across
different geographies and thereby limit their risks (Gart (1994), Hubbard (1994)). We label
this the diversification channel.
Finally, as pointed out by Boyd and De Nicolo (2005), banking deregulation increases
credit market competition, which leads to reduction in loan rates for borrowers and, thereby,
increases the ability of the borrowers to repay. Also, decreased loan rates reduce the moral
hazard problem on part of the borrowers by reducing their temptation to invest in risky
projects. The reduced moral hazard and increased inability to repay should together reduce
the chance of default by the borrower. As well, competition among banks forces managers
to improve the quality of loans by improving screening and monitoring and avoiding less
productive loans (Jayaratne and Strahan, 1996). We label this the loan loss channel. As
highlighted in Section III.B, intra-state deregulation had a significant effect on banking
market structure. Therefore, we develop the following contrasting hypotheses:
Hypothesis 1A: Intra-state deregulation leads to less bank failures.
Hypothesis 1B: Intra-state deregulation leads to more bank failures.
Hypothesis 1C: Intra-state deregulation has no effect on bank failures.
In contrast to intra-state deregulation, first, inter-state deregulation had no effect on
structure of banking markets. Second, though inter-state deregulation sharply increased
acquisitions among banks, this form of deregulation did not permit the newly acquired
banking assets to be folded into the acquirers banking operations outside the state (Strahan,
2002). Third, inter-state deregulation increased the threat of takeovers among banks and
led to improved managerial incentives to operate their banks efficiently (Berger, Kashyap
and Scalise, 1995). Consistent with a more active market for corporate control among banks
post-inter-state deregulation, Hubbard and Palia (1995) find evidence of increase in CEO
turnover and the sensitivity of CEO compensation to performance after deregulation. These
efficiency benefits from a more active market for corporate control among banks may lead
to reduced likelihood of bank failure due to inter-state deregulation. Fourth, inter-state
deregulation led to the emergence of larger banks through M&A, which could affect bank
failures through the “too big to fail” syndrome. This could ex-ante increase the likelihood of
bank failures by incentivising greater risk taking by the managers of large banks. However, if
bank regulators are more likely to bail larger banks, such regulatory forbearance may reduce
the likelihood of bank failures ex-post. Given these opposing ex-ante and ex-post effects, the
net effect of the “too big to fail” syndrome is ambiguous. Therefore, we predict that:
Hypothesis 2A: Inter-state deregulation leads to less bank failures.
10
Hypothesis 2B: Inter-state deregulation leads to more bank failures.
Hypothesis 2C: Inter-state deregulation has no effect on bank failures.
IV
Data and Proxies
This section describes our data and proxies.
IV.A
Bank Failures
We employ data on bank failures from FDIC’s Historical Statistics on Banking (HSOB).
For each year, HSOB provides information on the type of failure (liquidation or assistance),
charter type (bank or thrift), location (state) as well as the total deposits and assets owned by
each institution as of the last Call Report or Thrift Financial Report filed by the institution
before the failure. Although data on bank failures is available from 1934, we start our
sample in 1976 since data on assets and deposits from the call reports is available only from
1976. Also, even though the data is available for later years, following Black and Strahan
(2002), we choose to end our sample in 1994. The passage of Riegle-Neal inter-state Banking
and Branching Efficiency Act (IBBEA) in 1994 allowed nationwide branching for all FDIC
approved banks, which make state-level estimates of banking sector variables unreliable.
A concern with measuring bank failures at the state level may be that these measures
would be not very reliable post-deregulation. However, Bird and Knopf (2009) document
that in 1999, i.e. five years after the enactment of IBBEA, the proportion of banks that had
branch offices in more than one state was only 2.68%. Since by 1999, all fifty U.S. states
permitted interstate banking operations (Kroszner and Strahan, 1999) and since interstate
banking has been growing over time, they surmise that in the years prior to 1999, even
fewer banks possessed inter-state banking operations. Since we end our sample in 1994, it is
reasonable to assume few banks possessed inter-state banking operations during our sample
period. Therefore, in our case, the state-level estimates of bank failures are reliable even
after a state deregulates.
We classify bank failures by the method of its resolution by FDIC. These fall into three
categories. In a type I resolution, the institution’s charter is preserved and FDIC assists
it through open-bank assistance or other means. A type II resolution refers to an assisted
merger by FDIC, where the acquiring bank purchases the distressed bank’s assets and assumes its liabilities; in this case, the distressed bank’s charter is discontinued. Finally, a type
III resolution refers to the complete closure of the institution. In this type of resolution, all
the assets and liabilities of the institution are liquidated. Thus, type III failures would have
a greater detrimental effect on the economy than type II failures. As type I resolutions
only involve assistance by FDIC, they do not necessarily constitute a failure. We, therefore,
11
exclude type I failures from our analysis.
We use two proxies for bank failures: (i) the total deposits accounted for by failed banks
in a particular state, year as a proportion of the total deposits owned by all banks in that
state-year; and (ii) total assets accounted for by failed banks in a particular state, year as a
proportion of the total banking assets in that state-year. The dollar value of total deposits/
assets accounted for by failing banks is inappropriate since it changes due to the banking
sector in a state expanding or contracting. Similarly, any measure based on the number or
proportion of failing banks is inadequate because it fails to take into account the fact that
failure of larger banks may be economically more material than failure of small banks.
Figures 2 and 3 show the time trends in bank failures across several states in the U.S. Since
the states of Texas, Alaska, Oklahoma, Louisiana, Massachusetts, Connecticut, Tennessee
and Florida experienced the largest number of bank failures, we examine the trends in these
states individually. Figure 2 displays the trend in proportion of deposits and assets owned
by failing banks in these eight states and the rest of the U.S. Except for Louisiana and
Tennessee, failures were negligible at the start of the sample period and peaked in the late
80s and early 90s. In Louisiana (Tennessee), failures were high in the mid-70s and peaked in
the early 80s (late 80s). The largest number of bank failures occurred in the state of Texas.
In Figure 3, we find a similar trend in type II and type III failures as well. Table I reports
the summary statistics for the variables.
IV.B
Deregulation of Bank Entry
We use the year of inter-state and intra-state deregulation as in Jayaratne and Strahan
(1996). Our data is available for fifty U.S. states and the District of Columbia. Following
the practice in the literature, we drop Delaware and South Dakota from our analysis; the
banking system in these two states is very different from rest of the U.S. due to the presence
of credit card banks and laws favouring the credit card industry.3
IV.C
Control Variables
Bank failures are less likely in economies that are experiencing significant economic
growth as compared to the economies that are not. To control for this effect, we calculate growth rate of per capita Gross State Product (GSP) using data from the Bureau of
Economic Analysis and include upto three lags of this variable.
3
As a robustness test, in unreported tests, we repeat our analysis after including these two states and
find that all our key results remain unchanged.
12
V
Results
We describe our results in this section.
V.A
Effect of Deregulation on Bank Failures
We investigate whether deregulation of bank entry leads to lower bank failures. Since
bank failures may be expected to be largely collinear with other state-level unobserved
economic factors, we exploit state-level exogenous differences in the timing of branching
deregulation. Specifically, since geographic restrictions on banks were lifted gradually and
states deregulated at different times, we can use states that did not deregulate to control for
potentially confounding effects and thereby estimate a difference-in-difference: the difference
in the level of bank failures in a state before and after the deregulation compared to this
difference for states that did not undergo a deregulation during the same period.
To fix ideas, consider two states that deregulated at different points in time: New York
(NY) in 1976 and Massachusetts (MA) in 1984. Since MA had not deregulated till 1984, the
before-after difference in bank failures in NY due to the deregulation in 1976 when compared
against the before-after difference over the same period for MA provides a causal estimate
of the effect of the deregulation in NY in 1976. This is because the before-after difference in
bank failures in MA provides an estimate for the counterfactual question: what would have
been the change in bank failures in NY if the deregulation had not happened in 1976?
We estimate the effect of deregulation on bank failures using a panel regression:
ln(Ys,t+k ) = β s + β t + β1 intrast +
j=k
X
γ j Xs,t+j +
st , k
= 1, 2, 3
(1)
j=1
where Ys,t+k denotes, in different regressions, proportion of deposits involved in all bank
failures, Type II failures and Type III failures in state s at time t + k and intrast is a
dummy variable that equals one in the years after state s passes intra-state deregulation
law and zero otherwise. The coefficient, β 1 captures the difference-in-difference estimate
of the impact of intra-state deregulation on bank failures. Xst is a vector of time-varying
state level variables. β s and β t denote state and year fixed effects that control respectively
for state-specific, time-invariant and year-specific, state-invariant unobserved characteristics
that affect Ys,t+k .
The reasons for defining the dependent variables at the state, year level instead of bank
level are twofold. First, our key independent variable is defined at the state level. Therefore,
defining the dependent variables at the bank level could have led to a superficial correlation
between deregulation and bank failures due to variation in the dependent variables at the
13
bank level. This also ensures that omitted factors at the bank levels do not drive our results.
Table II presents the result of the test of regression equation (1). Panels A, B and C
respectively show the effect of deregulation on our dependent variables three, two and one
year after intra-state deregulation. Since deregulation should have a long-run effect on bank
failures, we first examine the effect on bank failures three years after deregulation in Panel
A. Examining the effect at least one year after deregulation enables us to mitigate concerns
related to simultaneity or reverse causality. Each regression includes up to three years of
per capita growth rate of GDP apart from state and year fixed effects. Also, we estimate
standard errors that are clustered by state to account for possible autocorrelation.
The results in Table II indicate that intra-state branching deregulation led to a significant
reduction in bank failures. The coefficient on intra-state deregulation dummy is negative and
statistically significant in all the specifications in Table II. When we compare the coefficient
of interest across panels A, B and C for each specification to examine the dynamic effect
of deregulation on bank failures, we find that the effect across time is almost identical. In
fact, this pattern was reflected in Figure 1 as well, where we observed that the effect of
the deregulation on bank failures stayed similar and extended more than a decade after
deregulation. Thus, we observe that the effect of the deregulation of entry on bank failures
manifests immediately (i.e. the year after the regulation) and persists in the long-run.
V.B
Effects of intra-state versus inter-state deregulation
In Table III, the separately assess the effect of intra-state deregulation vis-à-vis that of
inter-state deregulation, we run regressions to those in Table II after including inter-state
deregulation in the list of our explanatory variables:
ln(Ys,t+k ) = β s + β t + β1 intrast + β2 interst +
j=k
X
γ j Xs,t+j +
st , k
= 1, 2, 3
(2)
j=1
where β 2 captures the difference-in-difference estimate of the impact of inter-state deregulation. All other coefficients have interpretations identical to those described above. We
find that the coefficients on intra-state deregulation dummies continue to remain negative
and statistically significant in all the specifications. However, the coefficients on inter-state
deregulation dummies are insignificant suggesting that inter-state deregulation did not have
any effect on bank failures. Table A-I and Table A-II in the Internet Appendix confirm these
findings using the proportion of assets owned by failing banks as a proxy for bank failures.
The effect on proportion of assets owned by failing banks is similar to the proportion of
deposits owned by these failing banks both statistically and economically. In each of the
panels in Table III, we find that the coefficient on per-capita growth rate of GDP is negative
14
and significant, which suggests that bank failures were lower in states with higher per-capita
growth rate of GDP. This result is in line with expectations since high growth implies better
business opportunities for banks.
The result that bank deregulation is associated with large declines in both proportion
of deposits and assets owned by failing banks is consistent with Hypothesis 1A: banking
deregulation reduced bank fragility. As well, we find that only intra-state deregulation
had a significant effect on bank failures; inter-state deregulation is not associated with any
change in bank failures. These results are consistent with Hypothesis 2C and the findings
in the literature that banking structure changed (did not change) substantially after intrastate (inter-state) deregulation. Since M&A among banks increased sharply post inter-state
deregulation thereby leading to the creation of substantially larger banks, our results suggest
that the risk shifting incentives created by the “too big to fail” did not necessarily exacerbate
fragility in the banking sector.
V.C
Economic Magnitudes
We assess the economic magnitude of the effect of deregulation on bank failures based
on the results reported in Table III. Consider column 1 in panel A of Table III showing the
effect on all bank failures. To interpret the results in column 1 note that the mean of proportion of deposits owned by all failing banks is 0.00319 and the standard deviation is 0.0111.
The coefficient of −1.607 on the intra-state deregulation dummy implies that the proportion of deposits owned by all failing banks reduced annually by 79.96%(= exp(−1.607) − 1)
three years after deregulation. However, since the proportion of deposits owned by failing banks equals 0.00319 on average, which is quite small, year-on-year percentage changes
are misleading. Instead, we state the economic magnitudes as a percentage of the standard deviation of the proportion of bank deposits of failing banks. Therefore, intra-state
deregulation led to a reduction in proportion of deposits owned by all failing banks by
23.04%(= 0.7995 ∗ 0.0032/0.0111) of the standard deviation three years after deregulation.
Similarly, the coefficients of −1.859 and −0.526 in columns 2 and 3 in panel A imply that
three years after deregulation, proportion of deposits held by banks involved in Type II failures and Type III failures fell by 24.2% and 10.1% of the standard deviation respectively.
Clearly, the magnitude of reduction in failures is economically significant.
V.D
Dynamic Impact of Deregulation on Bank Failures
In this section, we look at the dynamics of the relationship between deregulation and
bank failures by including a series of dummy variables in our basic regression model:
−10
−9
+15
+ β 2 Dst
+ ... + β 25 Dst
+
Yst = β s + β t + β 1 Dst
15
st
(3)
where the deregulation dummies equal zero except as follows. D−j equals one for states
in the jth year before intra-state deregulation and for j = −10 it equals one for years that
are 10 or more years before deregulation. D+j equals one for states in the jth year after
the deregulation and for j = 15 it equals one for years that are 15 or more years after
deregulation. Yst is defined as before. β s and β t the present state and year fixed effects as
before. Year of deregulation is excluded from these regressions and thus the dynamic effect
of deregulation is relative to the year of deregulation. Figure 4 plots the results and the 95%
confidence intervals using the percentage of deposits lost as the dependent variable. Figure
A-1 in the Internet Appendix plots the results using the percentage of assets lost.
These figures reaffirm the conclusions of Table II and III that the decrease in our proxies
of bank failures took place only after the deregulation. The figure shows no clear trend
in our dependent variables before the year of deregulation intra-state. All our dependent
variables decrease immediately after deregulation and continue decreasing with some fluctuations through the next fifteen years. Thus, the effect of deregulation on bank failures is
quick and does not die down with time. This suggests that the channels through which bank
deregulation affects bank failures operate fast and continue long after deregulation.
V.E
Are our results due to the mechanical effects of M&A?
We have shown above that intra-state deregulation reduced bank failures. After intrastate deregulation, banks grew mainly by acquiring other banks located in the same state
and merging them into their own branching network. It could be argued that our results are
a manifestation of the mechanical effect of increased M&A post deregulation. Specifically,
inefficient banks may have been acquired by better run banks resulting in a weeding out of
weak banks from the system. Wheelock and Wilson (2000) explored this channel and found
that, on the contrary, high cost inefficiency lowered the probability of a bank being acquired.
Nevertheless, we alleviate concerns about such mechanical effects by examining the effect
of intra-state deregulation on banks of different sizes. To test for this effect, we divide
banks into two categories based on their size (as measured by their deposits). Table IV
displays the results of these tests. Panel A (B) shows the effects for small (large) bank
failures, i.e. those banks for which the deposits lost were smaller (greater) than the median
bank deposits lost due to bank failures in that particular state, year. Similar to our basic
regressions, we look at the effect on failures atleast one year after the deregulation. The
coefficient on intra-state deregulation is negative and significant for both the small and large
banks in all the regressions. Moreover, we find that the difference in the coefficients on
inter-state deregulation for small and large bank failures are statistically indistinguishable,
which suggests that the reduction in bank failures was uniform across all size categories.
16
Since small banks are more likely to merge or be acquired, the reduction in bank failures
should have been restricted to the small banks (or at least the effects for small banks should
have been economically larger) if the above results were a manifestation of the mechanical
effect of M&A among banks. The fact that our results our uniform across small and large
bank failures mitigates this possibility.
VI
Channels
In this section, we discuss the possible channels through which branch deregulation could
have led to the observed reduction in bank failures.
VI.A
Evidence on the Diversification Channel
As discussed in section III.C, portfolio diversification provided banks could potentially
important source of benefit post-deregulation. If such diversification was indeed responsible
for the observed reduction in bank failures, then we should see a greater reduction in bank
failures for unit-banking states. As banks in the unit banking states were allowed to open only
one branch, banks in these states were the least diversified. Therefore, by allowing banks
to open new branches, branching deregulation led to the greatest increase in diversification
opportunities for banks located in these states. To test this hypothesis, we interact the
intra-state deregulation dummy with a dummy indicating the presence of unit-banking laws
in a state prior to deregulation:
ln(Ys,t+3 ) = β s + β t + (β1 U nitBanks + β2 ) ∗ intrast +
j=3
X
γ j Xs,t+j +
st
(4)
j=1
where UnitBanks equals one for unit banking states and zero otherwise. The results of this
exercise are presented in Table V. The coefficients on the interaction terms are negative and
statistically significant in all regressions implying that bank failures reduced disproportionately more for unit-banking states as compared to states that allowed limited branching prior
to deregulation. Moreover, the coefficients on the intra-state deregulation dummy loose its
significance after inclusion of the interaction term, which suggests that the reduction in bank
failures were restricted primarily to the sixteen unit-banking states.
While the above provides indirect evidence for the benefits from portfolio diversification,
the also examine directly whether diversification by banks indeed changed post-deregulation.
The dependent variable in the regressions reported in Table VI employ a proxy for loan
diversification across four categories of bank loans: Real estate loans, Agricultural loans,
Commercial and Industrial loans and Loans to Individuals. This proxy is calculated as
one minus the Herfindahl index of loans across these four categories; thus, a higher measures
17
indicates greater diversification across these four sectors. The regression employed in columns
(1) and (2) in table VI are given respectively by:
ln(Yi,s,t+3 ) = β s + β t + β 1 intrast +
(5)
ist
ln(Yi,s,t+3 ) = β s + β t + β 1 intrast + β2 interst +
(6)
ist
where Yi,s,t+3 denotes the measure of diversification for bank i in state s in time t + 3. The
positive and significant coefficient on intra-state deregulation in columns (1) and (2) suggests
that portfolio diversification increased following intra-state deregulation but did not change
following the inter-state deregulation, which is consistent with the fact that only intra-state
deregulation had the negative effect on bank failures.
We then interact the dummy for intra-state deregulation with the unit banking dummy:
ln(Yi,s,t+3 ) = β s + β t + (β1 UnitBanks + β 2 ) ∗ intrast +
ist
(7)
and find that the coefficient on the interaction term is positive and significant. As well, as
we saw in table V, the coefficient of the intra-state deregulation dummy loses significance
once we include the interaction with unit banking states. These two results together suggest
that portfolio diversification by banks increased disproportionately more in the unit banking
states and, in fact, was restricted primarily to these sixteen states. The results in tables V
and VI thus provide strong support for the diversification channel.
VI.B
Evidence on the Efficiency Channel
Branch deregulation intensified competition in the local banking markets by allowing new
banks to enter freely and existing banks to expand unhindered. This increased competition
forced bank managers to cut down on costs, increase efficiency and improve quality of banking
services. Jayaratne and Strahan (1998) show that operating costs decreased by 8% after
intra-state deregulation. Their analysis also suggests that these cost reductions took place
because better run banks grew at the expense of their less efficient rivals. Banks that failed
to do so either exited or contracted and their market share was taken up by better run banks.
Moreover, removal of restrictions on expansion allowed banks to grow to their efficient
size and achieve the benefits of economies of scale. As large banks could achieve greater
economies of scale, they were able to reduce their costs more as compared to smaller banks.
The evidence in Table IV that the reduction in bank failures occured for both small and
large banks suggests that the operating efficiencies, i.e. cost reductions, and economics of
scale possibly manifested across banks of all sizes.
18
VI.C
Evidence on the Loan Loss Channel
Bank deregulation reduced bank failures possibly by decreasing loan losses of banks.
Competition forces managers to improve the quality of loans by improving screening and
monitoring and avoiding less productive loans. Consistent with such an effect, Jayaratne and
Strahan (1996) show that the fraction of non-performing loans, fraction of loans written-off
and fraction of loans to insiders, i.e. executives and principal shareholders, declined after
deregulation. As well, increased competition forces managers to lower interest rates charged
to borrowers. Strahan (2002) documents that average loan rates fell by about 19 (30) basis
points in the short (long) run. As Boyd and De Nicolo (2005) argue, a decrease in the
interest rate improves borrower’s ability to repay and reduces borrower moral hazard thereby
reducing loan losses. The decrease in loan losses by about 50% after intra-state deregulation
(Jayaratne and Strahan, 1998) is consistent with such a phenomenon.
VI.D
Benefits from an Active Market for Corporate Control?
As discussed in section III.C, inter-state deregulation led to a more vibrant market for
corporate control among banks. However, if the efficiency gains from a more active market
for corporate control led to the reduction in bank failures, inter-state deregulation should
have led to a greater reduction in bank failures, which is not what we observe. We therefore
infer that a more active market for corporate control did not contribute to lower bank failures
following deregulation.
VI.E
Benefits from Reduced Economic Volatility?
Reduced economic volatility due to branching deregulation may have led to lower bank
exposure to macroeconomic shocks thereby reducing the likelihood of bank failure. However,
the evidence seems to suggest that this channel may not have been material. First, Morgan
et. al. (2004) find that inter-state deregulation led to decrease in year-to-year fluctuations in
economic growth by integrating of banks across states. If the decrease in economic volatility
accounted for the lower bank failures, the results should have been stronger for inter-state
deregulation, which is however not the case. Furthermore, reduced economic volatility should
affect small banks relatively more as small banks are less diversified and as a result more
susceptible to failures following macroeconomic shocks. However, we find in Table VII that
bank failures decreased uniformly for banks of all size categories, which contradicts the above
prediction. We therefore conclude that the reduced economic volatility was unlikely to have
accounted for the lower bank failures after deregulation.
In sum, we conclude that banking deregulation lowered bank failures through three main
channels: efficiency gains, benefits from geographical diversification and lower loan losses.
19
VII
Robustness
This section looks at the robustness of our results.
VII.A
Reverse Causality
Our analysis rests on the assumption that the timing of branch deregulation was unaffected by the pre-existing pattern of bank failures. If the pre-existing pattern of bank failures
in a particular state affects the timing of deregulation in the state, then our analysis would
be flawed given concerns of endogeneity. Therefore, we test the validity of this assumption by
examining whether prior bank failures affected the timing of branching deregulation. Figure
5 shows that neither the level of bank failures before deregulation nor its rate of change
prior to deregulation explains the timing of branch deregulation. In a regression of the
year of deregulation on the average proportion of deposits lost due to bank failures before
deregulation or on the rate of change in the proportion of deposits lost in the years before
deregulation, the t-statistic on these bank failure proxies are 0.978 and 0.747, respectively.
Using a hazard model to study the determinants of deregulation, we provide additional
evidence that prior bank failures did not affect the timing of deregulation. We follow Kroszner
and Strahan (1999) and employ a Weibul hazard model where the dependent variable is the
log of expected time to branch deregulation given that the state has not already deregulated.
Once a state deregulates it automatically drops out from the analysis.
The results of the hazard model are reported in Table VII, where we report the results
using the percentage of deposits owned by failing banks to proxy the existing patterns of
bank failures. Since the results are almost identical using the percentage of assets lost, in the
main text, we only report the results using the percentage of deposits lost. Table A-IV in the
Internet Appendix reports the results using the percentage of assets owned by failing banks.
In all the regressions we control for the growth rate of per capita GDP in the state and
political economy factors from Kroszner and Strahan (1999) that where found to influence
the timing of deregulation. The political economy factors include: (1) share of small banks
among all banking assets in a state; (2) capital ratio of small banks relative to large banks
in the state; (3) an indicator that takes value 1 if banks may sell insurance; (4) relative size
of insurance markets in states where banks may sell insurance; (5) relative size of insurance
markets in states where banks may not sell insurance; (6) share of small firms among firms
in a state; (7) percentage of state governments controlled by Democrats; (8) an indicator
that takes a value 1 if the state is controlled by one party; (9) average yield on bank loans
in the state minus Fed funds rate; (10) an indicator for A state having unit-banking laws;
and (11) an indicator that takes the value 1 if state changed insurance powers.
20
We find that prior bank failures did not affect the likelihood that a state that has not
already deregulated does so in a particular year. Among the political economic factors,
first, we find that states where small banks own greater share of the banking assets/deposits
deregulated later. Second, states where larger firms operated were more likely to deregulate
later. Third, deregulation was likely to be later if the state was controlled by one party.
Fourth, states that had unit banking laws were more likely to deregulate later. These results
are very similar to those obtained in Kroszner and Strahan (1999).
VII.B
Omitted Variable Bias and Possible Placebo Effects
Despite the difference-in-difference estimation, omitted variables may affect our results.
For example, technological changes that may have led to the deregulation of bank entry,
could also account for the reduction in bank failures if such technological changes enable
banks to screen borrowers better. To address such concerns, we analyze possible placebo
effects by examining the effect of the state-level deregulation on failure of thrifts. Since the
Garn-St. Germain Act of 1982 had permitted thrifts to branch across state borders, bank
deregulation did not affect the entry barriers faced by thrifts. Furthermore, any technological
changes that may have enabled banks to screen better should allow thrifts to do the same as
well. Similarly, any economy-wide factors that may have affected bank failures would affect
failure of thrifts as well. Therefore, failure of thrifts represent a placebo effect in our setting.
In Table VIII, we present the results of our placebo tests. Since the Garn-St. Germain
Act was passed in 1982, we start our sample for these tests in 1983. The specification is as
in equation (1), where Ys,t+k now denotes a measure of thrift failures in state s at time t + k.
Columns 1-3 show the effect of branching deregulation on proportion of deposits owned by
failing thrifts 3, 2 and 1 year after deregulation respectively. The coefficient on branching
deregulation dummy is statistically insignificant at any reasonable level of confidence in all
the three specifications. Moreover, in column 2, which analyzes the effect of deregulation
on proportion of deposits two years after deregulation, the coefficient is positive. Table A-V
in the Internet Appendix shows the result of branching deregulation on proportion of assets
owned by failing thrifts. As in the case with deposits, the branching deregulation dummy is
not significant in any of the specifications.
These results provide strong evidence that our results are not driven by omitted variables
and strengthen our main finding that branching deregulation reduced bank fragility.
VII.C
Savings & Loans Crisis and Regulatory Forbearance
Several banks and financial institutions failed during the Savings and Loans (S&L) crisis
in the late 80s and the early 90s. Is it the case that our results are mechanical effect of the
21
S&L crisis? In a similar vein, it could be argued that the reduction in failures took place due
to regulatory forbearance exercised by the FDIC in late 1980s, which may have delayed the
failure of many banks. However, since banking deregulation in many U.S. states occurred
before the late 80s, any mechanical effect of the S&L crisis would stack the odds against
our finding the evidence that banking deregulation reduced bank failures. Nevertheless, we
test for the effect of the S&L crisis and regulatory forbearance exercised by the FDIC by
splitting our sample into a period before these two phenomena (1976-1985) and a period
after (1986-1994) and rerunning our tests for these two samples separately. We find that our
results are qualitatively similar for both the samples, which suggests that our results are not
an artifact of the bank failures during the S&L crisis or the result of regulatory forbearance
exercised by the FDIC.
VII.D
Effect of outlier states
Finally, since figure 2 shows that bank failures were most common in TX and AK, we
exclude these states from our sample and find that our results continue to hold, which
reassures that our results are not driven by these outlier states.
VIII
Conclusion
Existing theoretical and empirical studies provide conflicting arguments about the possible effects of banking deregulation on the stability of the banking sector. On the one hand,
it is argued that banking deregulation leads to excessive competition and thereby reduces
bank profits and threatens their stability. This line of reasoning represents a key reason
behind the geographic restrictions that persisted in the U.S. banking sector for the better
part of the last century. On the other hand, empirical studies find that banking deregulation
leads to decreases in operating costs and lower loan losses. However, since bank capital may
respond endogenously to deregulation, decreases in operating costs or loan losses may not
necessarily translate into reduced instances of bank failures.
In this study, we show that deregulation of bank entry indeed enhances bank stability
by reducing bank failures. By ruling out possible sources of omitted variable bias and
reverse causality, we identify the effect of deregulation on bank failures by exploiting the
staggered manner of deregulation by the U.S. states since the 1970s. Our results question a
popular narrative relating to the financial crisis that the crisis was an outcome of increased
deregulation of the banking sector during the last 20 years.
22
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