NEW EHES Working Paper about Bank Deregulation, Competition and Economic Growth

Bank Deregulation, Competition and Economic Growth: The US Free Banking Experience

Philipp Ager, assistant
professor at University of
Southern Denmark

What is the optimal level of bank competition? New research by Philipp Ager and Fabrizio Spargoli sheds light on this question by testing how the introduction of free banking laws between 1837 and 1863 affected bank competition and economic growth in US counties. With the introduction of free banking laws, governments gave up their power over bank chartering and allowed any individual to establish a bank provided that certain legal requirements were satisfied. Together with the change in bank-chartering policy, the other main feature of the 1837-1863 period was that the US did not have a central bank nor a prudential regulator as today. Hence, studying the US during the 1837-1863 period allows the authors to isolate the effects of bank competition from those of state implicit guarantees. Ager and Spargoli's central conclusion is that, in an institutional framework without a central bank and a prudential regulator, bank competition leads to more bank failures but enhances economic growth in the long run.

Their study finds that the introduction of free banking laws relaxed barriers to entry and allowed more banks to enter the market. Along with a higher degree of bank competition, the introduction of free banking laws also caused more bank failures. Since these two effects have opposite implications for the real economy, the authors assess whether the introduction of free banking laws had an overall beneficial or detrimental effect on economic growth. Their empirical evidence suggests that there is a positive and statistically significant link between the relaxation of barriers to bank entry and economic growth during the 1830-1860 period in US counties. Ager and Spargoli's estimates indicate that counties in states that adopted free banking laws experienced a 20% increase in output per capita.

The authors argue that the growth-enhancing effect of free banking laws is consistent with two explanations. First, bank competition promoted counties' financial development, as measured by loans per capita and money stock per capita. Second, bank competition determined efficiency gains in the banking industry. In particular, their estimates show that free banking laws decreased the probability of closure of incumbent banks, and led the inefficient incumbent banks to grow less than their more efficient counterparts. These findings are consistent with the literature on the finance-growth nexus, which argues that finance led growth.

Fabrizio Spargoli,
assistant professor at
Erasmus Research institute
of Management

An interesting implication of their empirical evidence is that, in a banking system without public safety nets, more frequent bank failures do not harm economic growth in the long run. Ager and Spargoli believe that their result might provide some guidance to regulators on the reform process that has started in the aftermath of the 2007-2009 financial crisis. Bank regulators should put more emphasis on reducing banks’ subsidy from state implicit guarantees rather than limiting bank competition. In order to have a banking system that stimulates economic growth, it is crucial to make additional efforts in promoting competition among banks. These efforts should be directed both to the resolution of banks in financial distress, which might hinder the growth of healthier banks, and to limit the risk of excessive concentration of banking activities, especially in those countries where a consolidation process took place in the aftermath of the 2007-2009 financial crisis.



The working paper can be found here: 
http://ehes.org/EHES_No50.pdf