Baffi Lecture 2013Financial development: Lessons from American Banking in the Early 20th

Century

Raghuram Rajan

Large literature on financial development Why do countries have differentially

developed financial markets and institutions? AJR, Beck, LLSV, Levine, Pagano, Perotti,

Strahan, Rajan and Zingales, Volpin What consequences does this have? Why is this interesting to a wider

economic audience? Finance as an example of economic

institutions.

2

Plan for the talk Why is financial history important?

American banking in the early 20th century is especially illuminating.

Outline theories of financial development Explain what light our findings shed on them.

Study one consequence of easier access to credit. Land prices in the agricultural boom and bust Impact on banks

Relate back to lessons for today

3

Why history? History repeats but also its

consequences persist Hysteresis

Can tease out economic forces Natural experiments with useful

identification American banking in the early 20th

century Importance of agriculture Local markets – proximity important Regulations as identification

4

Theories of financial development Colonial origin

LLSV (1997, 98) Colonialism and coercive political institutions

AJR (2001, 2002) Constituencies

Benmelech and Moskowitz (2005), Calomiris and Ramirez (2004), Kroszner and Strahan, Pagano and Volpin (2005), Perotti and Von Thadden (2006), Rajan and Zingales (2003a, 2003b)

Where do constituencies come from? Technology of production

Engerman and Sokoloff (2002), Marx, Rajan and Ramcharan (2011)

5

Technology of production and constituencies

Plantation agriculture => more concentrated land holdings => more concentrated wealth => stronger desire to control finance. Extract rents through other means

Sale of inputs (Ransom and Sutch (2001)) Fire sales of land Cheap labor (Galor et al. 2006)

Preserve access for themselves Insurance (Calomiris and Ramirez (2002))

Own banks themselves and extract rents in finance? 6

Hypothesis and main result : Rajan and Ramcharan, Journal of Finance (2011)

Unit of analysis – county in United States Financial development – proxied for by banks

per capita Landed interests proxied for by Gini coefficient

of land holdings Concentration endogenous -- Rainfall as

instrument Results

Counties in the United States where land holdings were concentrated had significantly fewer banks per capita, even correcting for state-level effects.

Moreover, credit appears to have been costlier, and access to it more limited, in these counties.

7

Banks per capita and land concentration

8

What is the channel?

Political influence Relative strength of landed interests

in the county compared to manufacturing

Relative proximity of landed interests to state capital

Can we make a stronger case by examining legislation?

9

Rajan and Ramcharan (2012 a) “Constituencies and Legislation: The Fight over the McFadden Act of 1927”

The McFadden Act of 1927 was one of the most hotly contested pieces of legislation in U.S. banking history.

The act was intended to force states to accord the same branching rights to national banks as they accorded to state banks.

Effect would be to increase competition. Finding:

Congressmen in districts in which landholdings were concentrated, and where the cost of bank credit was high and its availability limited, were significantly more likely to oppose the act.

What does greater access do? Positive for growth

E.g., Rajan and Zingales (1998) But can we have too much finance?

Credit booms and busts Recent experience

Use variation in credit availability across the United States to examine consequences when system shocked. Rajan and Ramcharan (2012b) “The Anatomy of a

Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s”

11

Findings Does access to finance affect asset prices in

the face of an exogenous shock to fundamentals?

Yes How does it work?

Easier to borrow with positive shock – higher leverage ratios

Not just level effect but sensitivity Does a temporary boom and bust,

exacerbated by credit, leave more permanent effects?

Yes, for generations Now to details

Exogenous shock: Commodity price boom (1914-20) and bust (1920-29)

Commodity price boom, accelerated in World War I as European production was disrupted, soared with the Russian Revolution.

Unanticipated rapid revival of European production after the quick end to the war, and the Russian export thrust, lead to a collapse in commodity prices

Variation in credit market development

Number of banks and bank density varied across counties in the United States.

Bank regulation offers an exogenous source of variation in credit availability.

13

Credit Market developments Mortgage debt per acre increased 135%

from 1910 to 1920. Borrowers put down only 10 percent of the

amount, obtain 50 percent from a bank, and get a second or junior mortgage for the remainder.

Loan repayments were typically bullet payments due only at maturity, so borrowers had to make only interest payments.

As long as refinancing was easy, borrowers did not worry about principal repayment.

14

Data

Land pricesUS Census 2600 counties, 1910, 1920, 1930, self reported.Bank dataMeasure credit availability based on proximity/bank density

Number of banks in county Banks per area in county Banks per capita in county

Data Agricultural commodity price shock

County specific index of agricultural price changes: cotton, fruits, corn, tobacco, rice, sugar and wheat

We weight the annual change in each commodity’s price by the share of agricultural land devoted to that commodity’s production in each county in 1910 to get the price change index

Plan of tests Show direct correlation between land

prices at peak and credit availability, correcting for fundamentals.

Use variations in regulation to better identify effects.

Show relative importance of fundamental shock, credit, and interactions.

Show correlation between credit availability and bank failure rates when shock reverses.

Show persistence of effects on land prices.

  Dependent Variable: Log Land Price Per Acre

  (1) (2) (3)VARIABLES 1900-1920

county and year fixed effects

OLS IV

log number of banks 0.0925**(0.0373)

log number of banks, 1910

0.277***

(0.0379)log number of banks, 1920

0.587***

(0.0775)Observations 8,137 2,478 2,464R-squared 0.954 0.742 0.752

Land Prices and Credit Availability

Plan of tests Show direct correlation between land

prices and credit availability, correcting for fundamentals.

Use variations in regulation to better identify effect of credit availability.

Show relative importance of fundamental shock, credit, and interactions.

Show correlation between credit availability and bank failure rates when shock reverses.

Show persistence of effects on land prices.

Distance and borders Banks could not lend across state lines

100 50 0 50 A B C D

Proximity likely mattered for lending

  (1)

VARIABLES Dependent Variable: Log

Price Per Acre in 1920,

Census   100 mile

window

log number of banks, 1920 0.187***

(0.0365)

In state banks 0-50 miles 0.117***

(0.0295)

In state banks 50-100 miles 0.00694

(0.0440)

Out of state banks 0-50 miles 0.0240***

(0.00788)

Borders, Banks and Land Prices

Plan of tests Show direct correlation between land prices

and credit availability, correcting for fundamentals.

Use variations in regulation to better identify effects.

Show relative importance of fundamental shock, credit, and interactions.

Greater sensitivity of prices to shock when more credit available

Show correlation between credit availability and bank failure rates when shock reverses.

Show persistence of effects on land prices.

Land Price Residual, Banks and Commodity Index

Plan of tests Show direct correlation between land

prices and credit availability, correcting for fundamentals.

Use variations in regulation to better identify effects.

Show relative importance of fundamental shock, credit, and interactions.

Show correlation between credit availability and bank failure rates when shock reverses.

Show persistence of effects on land prices.

  (1) (2) (3) (4)VARIABLES Bank Suspension Rate,

1920-1929Deposits Suspension Rate,

1920-1929  OLS  IV  OLS IVlog banks, 1920 0.0269*** 0.0171* 0.0198*** 0.0197**

(0.00510) (0.00973) (0.00433) (0.00813)

log banks, 1920, squared

-0.00410*** -0.00334 -0.00192* -0.00286

(0.00120) (0.00214) (0.00110) (0.00175)

Commodity Index, 1917-1920

-6.24e-05 -6.07e-05 -0.000682 1.94e-05

(0.000462) (0.000699) (0.000556) (0.000594)

Commodity index* log banks, 1920

0.000782 0.000951 0.00197 0.000235

(0.00108) (0.00172) (0.00152) (0.00156)

Observations 2,477 2,447 2,474 2,446R-squared 0.396 0.395 0.339 0.341

Banking Distress 1920-1929, Banks and Commodity Index

Plan of tests Show direct correlation between land

prices and credit availability, correcting for fundamentals.

Use variations in regulation to better identify effects.

Show relative importance of fundamental shock, credit, and interactions.

Show correlation between credit availability and bank failure rates when shock reverses.

Show persistence of effects on land prices.

  (1) (2) (3) (4) (5)VARIABLES Log Price

Per Acre, 1920

Log Price Per Acre,

1930

Log Price Per Acre,

1940

Log Price Per Acre,

1950

Log Price Per Acre,

1960

  IVlog banks, 1920 0.205** -0.104 -0.386*** -0.722*** -0.331***

(0.0820) (0.0710) (0.0859) (0.146) (0.105)

log banks, 1920, squared

-0.0585*** -0.0154 0.0408 0.130*** 0.0441

(0.0185) (0.0225) (0.0267) (0.0312) (0.0288)

Commodity Index, 1917-1920

0.0147** 0.0223*** 0.0197* 0.0185 0.00878

(0.00682) (0.00788) (0.0103) (0.0134) (0.0118)

Commodity index* log banks, 1920

-0.00264 -0.0903*** -0.104*** -0.0405 -0.0283

(0.0184) (0.0238) (0.0253) (0.0375) (0.0340)

Observations 2,454 2,454 2,453 2,454 2,454R-squared 0.928 0.874 0.836 0.747 0.777

The Evolution of Land Prices, Banks and Commodity Index

Summary of last paper Greater availability of credit

Made asset prices more sensitive to fundamentals, up to a point...

Raised land prices during the boom Led to greater bank failures in the

downturn. Affected land prices for a long time.

Prudent risk management suggests regulators could “lean against the wind”.

Ongoing work

Does the failure of local banks depress financing capacity and reduce asset liquidation values?

Do lower asset liquidation values lead to further bank failures? Distinguish between financing

capacity and poorer economic conditions through state borders.

29

Overall conclusion from study Financial development is, in part, driven

by political interests. Access to finance does increase the

response to real shocks. The induced volatility, when

accentuated by leverage, may have long lasting effects.

Partial financial development is not an unmitigated blessing.

30

Relevance for today

How do political interest play out? Income inequality and financial

access in USA in the 2000s (Bertrand and Morse (2012), Rajan (2009))

How to get the benefits of greater financial access without the costs.

31