Capital Ideas
March 2011
Many economists have consistently found a strong link between a well-developed financial market and robust economic growth. This suggests that liberalizing a heavily regulated banking system is one way to fuel growth. However, there is a limited understanding about how this relationship works. How would removing government intervention in bank lending decisions lead to a change in firm behavior as well as the structure and dynamics of industries?
The idea of "creative destruction" first noted by economist Joseph Schumpeter plays an important role in this process, according to a study titled "Banking Deregulation and Industry Structure: Evidence from the French Banking Reforms of 1985" by University of Chicago Booth School of Business professor Marianne Bertrand, Antoinette Schoar of the Massachusetts Institute of Technology, and David Thesmar of HEC Paris.
In a deregulated banking system, banks are less willing to provide loans to poorly performing firms, many of which may eventually be forced to close without the help of subsidized loans. In addition, new companies will find it more attractive to enter the market if they know that incumbent firms no longer have easy access to cheap credit. In this competitive environment, a higher rate of entry and exit of companies allows credit to be distributed more efficiently across firms, which, in turn, leads to faster growth.
The deregulation of the French banking industry in 1985 abolished subsidized loans almost entirely and gave banks the freedom to decide which companies to lend to and how much to charge. Competition between banks provided the incentive to sharpen their screening and monitoring practices so that only credit-worthy firms were given loans. Indeed, the study by Bertrand and her co-authors finds that after the reforms, French banks put more emphasis on the credit quality of borrowers when determining loan size and interest rates.
Moreover, companies that belonged to more bank-dependent industries prior to the reform engaged in more cost-cutting and restructuring after deregulation in order to improve their credit rating. Many more firms entered and left the market, especially in industries that relied heavily on bank loans. Stricter lending seems to force underperforming firms to shut down, allowing bank capital to be allocated to its most productive use.
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"banks are less willing to provide loans to poorly performing firms" It's a mutual feeling, isn't it? Banks aren't stalwarts of loans either, because the availability of private lenders renders bank loans nearly obsolete.
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