The Cost of Banking Regulation

Luigi GuisoEuropean University Institute

Paola SapienzaNorthwestern University

Luigi Zingales University of Chicago

Motivation• The banking sector is probably the most

intensely regulated sector. Why?– Benign view of government regulation: address

market inefficiency– Cynical view: government intervention is driven by

political and electoral interests,

• Two views hard to disentangle:– governments intervene more where markets fail

more => attempt to estimate the effects of bank regulation spuriously attribute a negative effect to bank regulation unless degree of market failure is controlled for (very hard).

The 1936 Italian Banking Law• Law restricted competition giving, for political

reasons, different types of banks a different flexibility to grow.

• For historical reasons different regions had a different composition of the banking sector => restrictions on competition bait in a different way.

• We use this exogenous variation to assess the impact that restrictions on competition have on the structure of the banking industry and on the economic performance of an area

A two-stage plan

• Look at how variation in competition across local markets affects:– Access to the loans market– Banks stability– Economic performance

• Show that these effects are induced by variation in the bite of regulation

A two-stage plan : 2

2) Show how removal of 1936 regulation, that took place in the 1990s, affects these same variables

– Effects of liberalization on local credit markets should differ depending on the bite of initial regulation

– Being imposed by the EU directive, this deregulation is also an exogenous shock

Two challenges• How to measure competition in local markets

=> Use information on interest rate mark-ups charged to individual firms in different local markets prior to deregulation

• Show that the differences in the bite of regulation across local markets are valid instruments for differences in competition – Predict competition– Are not driven by local characteristics (exogeneity)

Characterizing the 1936 regulation1. In response to the 1930-31 bank failures, Italy imposed

limits on banks ability to open branches and extend credit. 2. Each type of institution was given a geographical area of

competence (National, regional, provincial, town level)3. Limits hit different categories of banks differentially

- National banks could open branches only in large cities- Cooperative and local commercial banks could open within the

boundaries of the province they operated in 1936- Savings banks could expand within a region, which comprises

several provinces

4. Bottom line: regions with more savings banks and fewer cooperative banks were less limited by 1936 regulation

5. Regulation persisted until the early 1990s

Characterizing the 1936 regulation:2

• We rely on four instruments that summarize the structure of the banking industry across provinces in 1936 and capture differences in exposure to the 1936 regulation

• A lot of variability in instruments

Mean Med SD Fraction of bank offices owned by local banks (1936) 0.76 0.74 0.15N. of savings banks per million inhabitants (1936) 2.72 2.05 2.92N. of cooperative banks per million inhabitants (1936) 8.60 7.57 5.62Bank offices per million inhabitants (1936) 0.21 0.22 0.12

Measuring competition in local markets: 1

• Use data from the Firms Balance Database (30,000 firms per year)

• For one year prior to deregulation – 1990 - we can match them with Credit Register data

• Data: interest rate on loans charged by each single lending bank

• Firm characteristics

• Lending bank characteristics

Measuring competition in local markets:2

• Regress firm-bank-level interest rate as a spread on the deposit rate in a province on: – Firm controls to capture firm quality (return on

sales, leverage, size, firm propensity score)– Bank controls as proxies for efficiency (bank size,

return on assets, ratio of non performing loans, bank ownership (state owned)

– A full set of province dummies to capture the degree of competition in the local market

Measuring competition in local markets:3

• Take coefficient of province dummies as our measure of market power in the local market

• Transform them as

Competition = max[coefficient on provincial dummies] - (coefficient on provincial dummies)

• Province is the «natural» local market:– Relevant market for antitrust – Used by BI for authorizing new branches

The index of bank competition Prov Comp Prov Comp Prov Comp Prov Comp Prov CompCatanzaro 0.00 Potenza 1.39 Sassari 1.82 Imperia 2.20 Massa 2.62Benevento 0.03 Ascoli 1.40 Perugia 1.83 Ragusa 2.21 Firenze 2.64Sondrio 0.25 Bolzano 1.46 Milano 1.85 Ancona 2.23 Mantova 2.64Cosenza 0.39 Rovigo 1.49 Treviso 1.88 Trento 2.23 Aosta 2.65Napoli 0.53 Como 1.49 Lucca 1.90 Siena 2.24 Trieste 2.70Taranto 0.54 Nuoro 1.51 Torino 1.91 Vicenza 2.24 Piacenza 2.73Isernia 0.56 Avellino 1.54 Bari 1.91 Agrigento 2.27 Caltanisetta 2.79

Enna 0.65 Padova 1.56 Palermo 1.92 Terni 2.29 Parma 2.84Caserta 0.82 Frosinone 1.58 Laspezia 1.94 Bergamo 2.29 Udine 2.88Latina 0.87 Cagliari 1.60 Pistoia 1.96 L'Aquila 2.29 Reggio E. 2.88Chieti 0.93 Arezzo 1.63 Genova 2.01 Oristano 2.32 Bologna 2.94Salerno 0.98 Cremona 1.66 Siracusa 2.03 Cuneo 2.36 Forlì 3.02Brindisi 1.06 Verona 1.69 Alessandria 2.05 Trapani 2.37 Modena 3.33Reggio C. 1.11 Messina 1.70 Pordenone 2.09 Savona 2.43 Pesaro 3.39Vercelli 1.12 Teramo 1.70 Belluno 2.12 Foggia 2.45 Rieti 3.45

Matera 1.15 Catania 1.75 Gorizia 2.12 Macerata 2.49 Ravenna 3.63Lecce 1.21 Brescia 1.75 Pavia 2.13 Ferrara 2.49Pescara 1.28 Novara 1.76 Asti 2.13 Livorno 2.51Grosseto 1.35 Varese 1.79 Viterbo 2.17 Pisa 2.55Potenza 1.39 Roma 1.81 Venezia 2.18 Campobasso 2.58

Banking competition acrossItalian provinces

2,58 a 4,6 (18)2,21 a 2,58 (18)1,83 a 2,21 (18)1,4 a 1,83 (20)0 a 1,4 (19)

Variability in the index of bank competition

I II

Fraction of bank offices owned 1.167*** 1.296***

by local banks in 1936 (0.472) (0.453)

Number of savings banks per 1000 79.946*** 92.710***

inhabitants in the region in 1936 (27.818) (25.507)

Number of cooperative banks per 1000 -19.946

inhabitants in the region in 1936 (14.42)

Bank offices per 1000 inhabitants 1.429

in the region in 1936 (0.860)

Observations 93 93R-squared 0.269 0.2234

F-test for all 1936 variables' coefficients =0 8.08 14.24Effect (1 SD is Saving/pop) 239 bp

Index of bank competition

Did 1936 regulation affect bank competition?

Are the Instruments Really Orthogonal?

• We need to show that

1. the number and composition of banks in 1936 is not linked to some characteristics of the region that affect the ability to do banking in that region and of firms to grow (economic development at the time);

2. this regulation was not designed with the needs of different regions in mind, but it was ``random";

3. the reason why this regulation was maintained until the 1990s has nothing to do with the actual needs of different regions.

A Primer in Italian Banking History -1

• Savings Banks are the first to be created – Imported from Austria – Spread in the North-East first– Then in Tuscany and the Center– Non Profit– Controlled by the local nobility

Savings banks per million people in 1936

A Primer in Italian Banking History -2

• The second wave of bank creation has– Big commercial banks (later nationalized) in the big

cities (Milan, Genova)– Cooperative banks in the rest

• Between 1926 and 1936 major consolidation– Savings banks from 200 to 91– Commercial banks from 737 to 484 – Cooperative banks from 625 to 473.

• Consolidation is not market driven– Big banks and to some extent Savings banks are

bailed out

A Primer in Italian Banking History -3

=> We show that banking structure in 1936 is not linked to level of economic development at that time (even after we control for South).

Regulation was “random”• The law supported savings banks for

political and not economic reasons:– Savings banks controlled by local aristocracy,

which supported the Fascist Regime– Savings banks contributed money to the

Fascist welfare system (Fascist youth organization)

• It constrained big banks because:– Responsible for the 1930s collapse– Regime hostile to Comit

Why was it maintained?

• for the desire to see the power of the Central Bank vis-a-vis the banking system strengthened" (De Cecco, 1968, p. 67).– reduces their lobbying power– fragments the electors of the Bank

Governor

• Christian Democrats inherited the Fascist clientele system

Data • Use three datasets

– Province level data on: number of firms, bad loans and economic growth before and after deregulation

– Survey of Households Income and Wealth: data on access to credit before and after deregulation

– Survey of Investment in Manufacturing: data on access to credit before and after deregulation

– Look first at effects of regulation• Data prior to deregulation

OLS IV IVDegree of bank competition -0.0074*** -0.0177*** -0.0170**

(0.002) (0.006) (0.0081)Percentage of firms bankrupts 0.0004** 0.0004** 0.0004*in the province (0.0002) (0.0002) (0.0002)Percentage of bad loans in the prov. 0.0016 -0.0005 -0.0005

(0.0017) (0.0025) (0.0025)Controls YES YES YES(income, wealth, demographics) South dummy 0.0008

(0.007)Observations 16451 16451 16451Effect (1 sd in degree of comp.) 20% 50% 50%R-squared 0.022 0.02 0.02

Probability a household is rationed

The effect of regulation of entry on rationing: households

OLS IV IVDegree of bank competition -0.0059 -0.0258** -0.0270**

(0.0053) (0.0122) (0.0128)Share of exported output -0.0011 0.0019 0.0024

(0.0144) (0.0144) (0.0146)Firm is state-owned 0.0548*** 0.0509*** 0.0504***

(0.0151) (0.0149) (0.0152)Log(employment) -0.0139*** -0.0142*** -0.0139***

(0.0021) (0.0022) (0.0022)Controls (firm is hiring, firm is firing, YES YES YES% of exported output, firm state-ownedpast investment/sales )Year dummies YES YES YESSouth dummy 0.0088Observations 8,126 8,126 8,126Effect (1 sd in comp.) 0 43% 46%

Probability a firm is rationed

The effect of regulation of entry on rationing: firms

OLS IV OLS VIII

Competition in the local 0.217* 0.802* 0.179 1.908**

banking market (0.125) (0.427) (0.315) (0.948)

South dummy -0.092 -0.147 0.304 0.142

(0.404) (0.432) (0.970) (1.055)

Provincial GDP per capita -1.800** -2.766*** -2.523 -5.378**

(0.726) (0.987) (1.744) (2.541)

Observations 95 95 95 95

Effect (1 sd in competition) 20% 75%

Value of bad loansNumber of bad loans

The effect of restriction on competition on bank stability

OLS IV OLS IV

Competition in the local banking 0.588*** 2.318*** 0.086 0.344**market (0.162) (0.854) (0.056) (0.162)Log of prov. GDP

1.065 -0.197 -2.237*** -2.296***(1.007) (1.560) (0.154) (0.189)

South dummy -0.717 0.031 -0.895*** -0.718***(0.539) (0.998) (0.086) (0.167)

Investment/GDP -0.081 -0.113(0.052) (0.071)

Observations 103 103 95 95Effect (1 sd in comp) 0.33 per 2 per a quarter of a

100 inhab. percen. point

Number of firms Growth rate

Effect of regulation of entry on number of firms and economic growth

Summary thus far – Bank competition has positive economic

effects– Regulation that inhibits competition has

some benefit in terms of “stability” but overall imposes relevant economic costs

– What happens when restrictions are removed? Interesting because:

• Gives an independent validation of the causal nature of this relationship

• can give us a sense of the costs and benefits of deregulation (relevant for developing countries)

The effect of deregulation

• Rationing

• Number of firms and growth

• Bank stability (bad loans)

OLS IV

Degree of bank competition -0.0087*** -0.0211***

(0.0023) (0.0063)

Competition*liberalization dummy 0.0078* 0.0235***

(0.0045) (0.0074)

Percentage of f irms bankrupt 0.0001 0.0001

(0.0002) (0.0002)

Percentage of bad loan in the province -0.0000 -0.0006

(0.0013) (0.0019)

Controls YES YES

(income, w ealth, demographics)

Observations 29102 29102

R-squared 0.014 0.012

Probability a household is rationed

Deregulation and credit rationing to households

Change in bad loans (number) bad loans (quantity)

OLS IV OLS IV

Competition in the local -0.419** -1.690** -0.892 -3.712**

banking market (0.211) (0.675) (0.599) (1.588)

South dummy 0.574 0.694 -2.621 -2.356

(0.579) (0.676) (2.224) (2.346)

Log of provincial value added pro capita in 1981 -0.782 1.316 -3.970 0.684

(1.106) (1.605) (3.858) (4.976)

Change in

Effect of deregulation on efficient allocation of credit

Effect on growth

More restricted provinces should grow more after liberalization

OLS OLS IV

Competition in the local -0.002** -0.002** -0.004***banking market (0.001) (0.001) (0.002)

Change in the log of the -0.024*** -0.025*** -0.025*** value added: beginning of period(0.002) (0.003) (0.003)

Change in infrastructural investments -0.001* -0.001

(0.001) (0.001)Observations 103 103 103R-squared 0.508 0.521 0.470

Change in growth Rate

Conclusions : 1 We started the project hoping to find an

answer to the following questions: a) Does regulation make it harder or

easier to access the credit market?b) Does it increase or decrease stability?c) How does regulation impact the

outcome of deregulation? • In terms of economic performance• In terms of financial stability

Conclusion: 2

• Our evidence provides tentative answers – restrictions to competition reduce the supply

of credit but also reduce the percentage of bad loans

– Deregulation boosts the supply of credit but increases the percentage of bad loans.

– Overall, restrictions on competition have negative effects on aggregate growth, which are undone when bank regulation is lifted.