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The Effects of Banking Competition on Growth and Financial Stability: Evidence from the National Banking Era

Journal: Journal of Political Economy

Date: 20220201

Author: Carlson, Mark; Correia, Sergio; Luck, Stephan

Abstract:
How does banking competition affect credit provision and growth? How does it affect financial stability? In order to identify the causal effects of banking competition, we exploit a discontinuity in bank capital requirements during the nineteenth-century National Banking Era. We show that banks operating in markets with lower entry barriers extend more credit. The resulting credit expansion, in turn, is associated with additional real economic activity. However, banks in markets with lower entry barriers also take more risk and are more likely to default. Thus, we provide causal evidence that banking competition can cause both growth and financial instability.

Link: Google Scholar

Key Findings

Lower Entry Barriers Led to More Credit

Banks in markets with lower entry barriers extended 12-15% more credit and saw higher deposit growth over the following decade.

Competition Increased Bank Risk

Banks in more competitive markets were 8% more likely to fail and had higher loss ratios, indicating increased risk-taking behavior.

Real Economic Growth Trade-off

Areas with lower entry barriers showed higher economic growth but greater financial instability, with higher per capita farm output and manufacturing capital.

Credit Growth and Bank Balance Sheets

  • Banks in competitive markets showed 12-14 percentage points higher loan growth
  • Deposit growth was 11-13 percentage points higher in competitive markets
  • Total assets grew 9-10 percentage points more in competitive markets

Bank Risk and Failure Rates

  • Banks in competitive markets had 8% higher probability of failure
  • Loss ratio was 4 percentage points higher in competitive markets
  • OREO holdings were 8 percentage points higher in competitive markets

Real Economic Effects

  • Per capita farm output was $9-11 higher in competitive markets
  • Manufacturing capital was $23-26 higher per capita in competitive markets
  • Effects were stronger in the 1880s and 1890s compared to the 1870s

Contribution and Implications

  • First causal evidence that banking competition can drive both economic growth and financial instability
  • Demonstrates that entry barriers alone can affect bank behavior, even without changes in market concentration
  • Provides insights into the trade-off between economic growth and financial stability in banking regulation

Data Sources

  • Balance sheet growth data from Table 4 showing loan growth differentials between competitive and less competitive markets
  • Risk metrics derived from Table 6 showing bank default rates and loss ratios across different market types
  • Economic effects data from Tables 8 and 9 showing per capita differences in farm output and manufacturing capital