A Look at Banking Deregulation and its Effects on the U.S. Macroeconomy Kyle Myers June 17, 2004

Objectives Provide samples of common arguments for and against Deregulation Provide samples of common arguments for and against Deregulation Examine literature on Deregulation as it pertains to effect on the macroeconomy Examine literature on Deregulation as it pertains to effect on the macroeconomy Attempt to quantify the relationship between deregulation and the economy Attempt to quantify the relationship between deregulation and the economy Weigh arguments for and against regulation Weigh arguments for and against regulation Propose final recommendations Propose final recommendations

Arguments Against Deregulation Smaller banks are more profitable and efficient Smaller banks are more profitable and efficient Small business loans will decline Small business loans will decline “Too Big to Fail” Status “Too Big to Fail” Status

Arguments For Deregulation Economies of Scale Economies of Scale Global Competition Global Competition Increased Diversification Increased Diversification Increases Competition Increases Competition

Literature Review Boyd & Graham (1991) – “Investigating the Banking Consolidation Trend” Offer arguments against economies of scale reasoning for consolidation Offer arguments against economies of scale reasoning for consolidation Point out data that shows economies of scale reached when a banks total deposits equal $100 million Point out data that shows economies of scale reached when a banks total deposits equal $100 million 3,000 banks in 1988 had deposits in that range 3,000 banks in 1988 had deposits in that range Provide data showing that from 1972 to 1990 larger banks have: Provide data showing that from 1972 to 1990 larger banks have: o Lower ROA (net income as a % of total assets) o Lower ROE (net income as a % of equity capital) o Less Financial leverage (equity capital as a % of total assets) …than smaller banks

Literature Review Famulla (1999) – “Insights Into Accenture’s Financial Services Consumer Index” Contains data from showing measures of revenue and profit for different bank sizes Contains data from showing measures of revenue and profit for different bank sizes Shows that medium sized banks bring in more revenue per customer and earn larger profits per customer than larger banks. Shows that medium sized banks bring in more revenue per customer and earn larger profits per customer than larger banks. Bank Size Definitions Super large banks (more than $80 billion in assets) Super large banks (more than $80 billion in assets) Large banks ($35 - $80 billion in assets) Large banks ($35 - $80 billion in assets) Medium banks ($10 - $35 billion in assets) Medium banks ($10 - $35 billion in assets) Small banks (less than $10 billion in assets) Small banks (less than $10 billion in assets)

Literature Review Kwan (1997) – “Efficiency of U.S. Banking Systems” Contends that optimal size of large banks is well below that of today's megabanks. Contends that optimal size of large banks is well below that of today's megabanks. Points out that “…that finding may be obsolete given the dynamics of the banking industry. With significant regulatory changes, rapid technological breakthroughs, and constant product innovations, the right size for yesterday's environment may no longer be optimal today, much less for the future.” Points out that “…that finding may be obsolete given the dynamics of the banking industry. With significant regulatory changes, rapid technological breakthroughs, and constant product innovations, the right size for yesterday's environment may no longer be optimal today, much less for the future.”

Literature Review Evanoff and Örs (2002) – “Local Market Consolidation and Bank Productive Efficiency” Performed study that measures bank efficiency before and after a merger takes place in a certain region. Performed study that measures bank efficiency before and after a merger takes place in a certain region. Finding was that efficiency increases though not necessarily at the bank that was acquired. Finding was that efficiency increases though not necessarily at the bank that was acquired.

Literature Review Horwitz and Selgin (1987) – “Interstate Banking: The Reform That Won’t Go Away” Predict that interstate mergers will lead to diversification, inter-bank funds movement, and reduced bank failures. Predict that interstate mergers will lead to diversification, inter-bank funds movement, and reduced bank failures.

Literature Review Strahan (2002) – “The Real Effects of U.S. Banking Deregulation” Attempts to tie the economic effects of deregulation into the macroeconomy by measuring state growth, entrepreneurial activity, and business cycle stability. Attempts to tie the economic effects of deregulation into the macroeconomy by measuring state growth, entrepreneurial activity, and business cycle stability. Found positive effect on state growth rates and entrepreneurial activity Found positive effect on state growth rates and entrepreneurial activity o Growth rates went up.5%-1.0% from o Increase in corporation formation per capita of 9.8% over same period

Literature Review Demirgüç-Kunt, Laeven, and Levine (2003) “The Impact of Bank Regulations, Concentration, and Institutions on Bank Margins” Review impact of deregulation on global scale Review impact of deregulation on global scale Findings are that banking regulations effect bank incomes across globe Findings are that banking regulations effect bank incomes across globe Authors used net income as measure of bank success which is what I used in my statistical analysis Authors used net income as measure of bank success which is what I used in my statistical analysis

Literature Review Burger and Humphrey (1997) “ Efficiency of Financial Institutions: International Survey and Directions for Future Research ” Found no significant cost savings, on average, attributed to mergers Found no significant cost savings, on average, attributed to mergers Submit that when banks do become more profitable after mergers it may be due to product mix, as opposed to cost efficiencies Submit that when banks do become more profitable after mergers it may be due to product mix, as opposed to cost efficiencies

Literature Review Yi-kan, Mason, and Higgins (2001) “ Does Bank Efficiency Change With the Business Cycle ” Also support Gilbert’s (1997) arguments that the entry of large banks into a local area, positively effect those area bank’s efficiency; in other words competition is good for efficiency. Also support Gilbert’s (1997) arguments that the entry of large banks into a local area, positively effect those area bank’s efficiency; in other words competition is good for efficiency. Find that the macroeconomy does have an effect on banking efficiency Find that the macroeconomy does have an effect on banking efficiency

Causality In the early Twentieth Century, Joseph Schumpeter argued that efficient financial systems promote innovations; hence, better finance leads to faster growth. In the early Twentieth Century, Joseph Schumpeter argued that efficient financial systems promote innovations; hence, better finance leads to faster growth. Joan Robinson (1952) believed that the causality was reversed; economies with good growth prospects develop institutions to provide the funds necessary to support those good prospects. Joan Robinson (1952) believed that the causality was reversed; economies with good growth prospects develop institutions to provide the funds necessary to support those good prospects. In other words, the economy leads and finance follows. In other words, the economy leads and finance follows.

Tie To Macroeconomy Did rate of GDP change after Deregulation? Did rate of GDP change after Deregulation? Is there a relationship between GDP and bank net income? Is there a relationship between GDP and bank net income?

Methodology Strategy Strategy I. Establish way to measure relationship between banking industry profitibility and Macroeconomy II. Use net income and GDP respectively as a proxy for those relationships III. Comparative analysis; regulation vs deregulation era

Findings High Correlation (.9478) between Bank Net Income and GDP High Correlation (.9478) between Bank Net Income and GDP Implies that there is a positive relationship with respect to movement between GDP and Bank Net Income Implies that there is a positive relationship with respect to movement between GDP and Bank Net Income Statistically Significant Difference between pre and post Deregulation Bank Average Income Statistically Significant Difference between pre and post Deregulation Bank Average Income

Correlation Chart ’87 Market crash

Limits Limited by data on commercial banks insured by FDIC only…may not be representative on entire banking industry Limited by data on commercial banks insured by FDIC only…may not be representative on entire banking industry May be other factors effecting bank profitability that have nothing to do with Deregulation efforts May be other factors effecting bank profitability that have nothing to do with Deregulation efforts

Conclusion Deregulation is good for the economy, at least in the short run Deregulation is good for the economy, at least in the short run My Opinion: Many bank regulations that were in effect protected private interest, not public My Opinion: Many bank regulations that were in effect protected private interest, not public

Recommendations Maintain current regulatory acts regarding banking Maintain current regulatory acts regarding banking Address “Too Big To Fail” concern through antitrust that is applicable to all industries Address “Too Big To Fail” concern through antitrust that is applicable to all industries

Questions?