How Local Bank Competition Boosts the Economy

Tuck professor Gordon Phillips finds new evidence that more local banks are good for business.

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A new Tuck study finds that, for smaller businesses, debt can be a catalyst for fast growth.

Before the idea of bank deregulation conjured thoughts of the Troubled Asset Relief Program, collateralized debt obligations, and investment banks that were too big to fail, it meant something far more benign.

Between the 1970s and the early 1990s, it referred to the process whereby states lifted restrictions on the ability of banks to open new branches and acquire banks across state lines. Those restrictions were designed to protect local banks, but they had the unintended effect of hurting local businesses by reducing competition among banks and decreasing the supply of credit. That era of state banking restrictions came to a close in 1994 with the passage of Riegle-Neal Interstate Banking and Branching Efficiency Act, which enshrined the state-level deregulation in federal law.

Since then, researchers have concluded that the deregulation was associated with economic growth, but they didn’t know the precise mechanism behind the change. A new paper by Gordon Phillips, the C.V. Starr Foundation Professor at Tuck, sheds more light on the question. In “The Impact of Bank Credit on Labor Reallocation and Aggregate Industry Productivity,” which is forthcoming in the Journal of Finance, Phillips and co-authors John Bai of Northeastern University and Daniel Carvalho of Indiana University examine U.S. Census data on half a million small firms between 1977 and 1993 to better understand how bank deregulation impacted their ability to borrow money and reinvest it in their business.

Bank financing, or corporate debt, often comes with a negative connotation. People worry that firms in debt must forego new business opportunities or can’t invest in research and development. But for smaller businesses, debt can be a catalyst for fast growth. That’s what Phillips found when he looked at the small firms that suddenly had access to competitive interest rates when, after deregulation, new banks moved into local markets and began looking for business. “The existing small banks didn’t have as much capital and didn’t offer competitive rates,” Phillips says, “so when the national banks came in, they actually made it easier for local firms to borrow money.”

And what did those firms do with their newly borrowed money? “What was surprising to us,” Phillips explains, “is that they used it to help finance increased employment. So the number of employees went up.” Such businesses might, for instance, take on a new product order which requires more labor. They then use a line-of-credit to fund new working capital and to pay the new employees before the company gets paid by their customer. The aggregate effect of hundreds of thousands of small firms adding employees was greater productivity and growth at a national level.

This effect was strengthened by the types of businesses that took advantage of the new credit. It wasn’t the big, established firms. They could self-finance, or seek credit in the national or global financial markets. It was the younger and smaller firms that benefited most. These companies might not have an established relationship with a local bank, and they weren’t big enough to shop in the national market. Moreover, these younger companies tended to be highly productive, a quality that was aided by their improved access to lending.

This research follows a thread in Phillips’s work: looking at the unintended consequences of financial regulation. In a recent working paper, for example, Phillips studied the effect of restrictions of mergers and acquisitions on venture capital activity, finding the two to be closely linked. The M&A regulations were designed to prevent consolidation and foster competition, but they also resulted in fewer startups, since venture capitalists didn’t see a clear exit strategy. Here, what began as an effort to help local banks ended up hurting local businesses. “The general theme is you don’t want to put a lot of regulation on peoples’ ability to do business in one market, because it can have adverse, unintended consequences on other markets,” Phillips says.