By Ross Levine, University of California, Berkeley
Introduction: Although it is popular to demonize bankers and their banks, abundant research demonstrates that well-functioning banks boost living standards, especially among lower-income workers.
Alexander Hamilton, the first Secretary of the U.S. Treasury and the father of the U.S. financial system, argued that banks are “the happiest engines that ever were invented for advancing. Venice, Genoa, Hamburg, Holland, and England are examples of their utility. They owe their riches . . . to this source.” In the wake of the global financial crisis, however, many have come to question whether bankers and their banks foster economic prosperity.
Those stressing the beneficial impact of banks on economic prosperity argue that well-functioning banks provide indispensable services. When banks screen borrowers effectively and identify firms with the most promising prospects regardless of the wealth and connections of the owners of those firms, this is a first step in stimulating economic growth and expanding economic opportunities.
The second step is when banks mobilize savings from disparate households to invest in these promising projects. When banks carefully monitor how their loans are being used and scrutinize managerial performance, this is an additional, essential ingredient in boosting the operational efficiency of firms and reducing waste and fraud. But that’s not all. Banks also provide key roles in providing liquidity, helping firms and individuals manage risk, and facilitating transactions. When banks engineer effective risk management tools, this allows more savings to flow to high-return projects that propel the economy forward. When banks create liquid assets for firms and savers, this also boosts the efficiency of resource allocation and accelerates economic growth. And when banks perform their roles as market makers and facilitate an array of transactions, these functions, too, help get resources to where they will be most effectively employed.
Those emphasizing the harmful effects of banks stress that too often banks collect savings with one hand and pass them along to cronies, the wealthy, and the politically connected with the other. They stress that bankers devote little effort to exerting effective governance over corporate managers to enhance the use of society’s savings and instead devote considerable effort to lobbying politicians and regulators for favorable treatment and protections. They argue that banks do not capably provide risk management tools, create liquid securities for households and firms, or make efficient, stable markets for financial transactions.
Who Is Right?
In this article, I’ll evaluate the evidence on the impact of banks on long-run economic prosperity. I’ll also consider what is happening to the living standards of people across the distribution of income by assessing whether better-functioning banks promote only the incomes of the rich or if the benefits trickle down to lower-income workers. I’ll focus on the long run and review evidence on how banks affect changes in living standards over decades.
I’ll discuss evidence from around the world on how the functioning of banks shapes economic prosperity as well as evidence from across the U.S. on how regulatory reforms that enhanced the functioning of banks influenced the living standards of people across all strata of society. While there are many voices on each side of the theoretical debate about banks and prosperity, we will see that the empirical evidence speaks with a singular voice.
Cross-Country Approach
One method of evaluating the connection between banks and prosperity is to test whether cross-country differences in banking systems explain the economic performance of countries. Cross-country evaluations use one observation per country, where the data are typically averaged over 30 or 40 years. The studies control for many other possible determinants of economic growth, such as initial income, educational attainment, inflation, government spending, openness to trade, and political instability. Thus, these studies seek to isolate the relationship between banks and economic performance by controlling for many other features of the economies.
Cross-country studies face a big challenge: measuring the functioning of the banking system. We would like to measure how well the banking system identifies and funds the best firms, exerts effective corporate governance over managers, mobilizes savings from households, and provides risk management tools to firms. However, it has proven prohibitively difficult to get detailed and comparable measures across countries as diverse as Brazil, China, and Switzerland and covering the period from 1960 to the present.
It has become popular to use private credit, which equals bank credit to the private sector as a share of GDP, as a measurement. The reasoning behind this measure is this: If banking systems function poorly, people will be less likely to save in them, so private credit will be small. For example, if banks simply provide loans to friends and the powerful, they will be unable to offer good returns to savers; this will encourage them to put their money under their mattresses, save in other countries, or spend it rather than get meager returns. Thus, the resultant small value of private credit will provide a valuable signal of how well the financial system is functioning. Furthermore, since private credit excludes loans to the government and state-owned enterprises, if banks are serving little role except passing along the deposits it collects to government entities, this will be appropriately captured in a low value of private credit. While imperfect, private credit provides information about the functioning of a banking system, and it’s worth noting that the same results reported below hold when using broader measures of the financial system, such as non-bank financial institutions, and when incorporating measures of stock market development.
A country’s legal, regulatory, and political systems are key factors that help explain cross-country differences in banking sector development as measured by private credit. When national legal systems ineffectively enforce contracts, this stymies the functioning of banks, leading to lower levels of private credit. In contrast, when legal systems lower the costs of writing and enforcing and contracts, this boosts banking sector development.
Regulatory and supervisory systems also play a fundamental role in shaping the functioning of banking systems. Granting greater power to official supervisory and regulatory agencies often damages the operation of banks. From the most developed economies to the least developed ones and across centuries of experience, research shows us that it is often the regulatory agencies that implement policies that discourage banks from effectively screening borrowers and allocating capital efficiently; it is often the regulatory agencies that compel banks to make loans to politically appealing ends that turn out to be economically unproductive and harm economic prosperity; and it is often public institutions — including public banks — that redirect the flow of credit to cronies and constituents in ways that restrict economic opportunities to the connected and limit the ability of the most promising entrepreneurs to flourish. While every government and every regulatory agency believes that it can manipulate the levers of banking policies to achieve socially productive outcomes, the evidence raises a cautionary flag about approaches that rely on the guiding hand of government.
Furthermore, when an economy’s bank regulations limit competition among banks, the following tends to occur: bank lending rates rise, deposit rates fall, the proportion of past-due loans increases, and private credit falls. Regulatory policies that interfere with operation of competitive markets tend to hurt the functioning of banking systems.
Finally, and perhaps most importantly, regulatory and supervisory approaches that make it easier for markets to monitor banks and exert effective corporate governance over bank activities tend to enhance the functioning of banks. This research finding is not an argument for a laissez-faire approach. Rather, evidence from around the world shows that policies that force banks to disclose accurate, comparable information to markets enhance market discipline of banks and boost private credit without increasing banking system fragility.
Banks and Prosperity
Figure 1 illustrates that countries with better-developed financial systems — i.e., bigger values of private credit — grow faster even when controlling for many other possible determinants of economic growth. The figure does not simply graph growth against financial development; it illustrates the relationship between growth and financial development after accounting for the many other potential growth determinants noted above. Furthermore, research extends these results and shows that financial development boosts growth primarily by enhancing the efficiency of capital allocation. It is not the impact of banks on national savings rates that boosts economic growth; it is the choices that banks make in allocating those savings that shape national growth rates.
The operation of the financial system can also influence the distribution of income in a variety of ways. First, if better-functioning banks focus more on a person’s ideas and abilities than on family wealth and political connections when allocating credit, then improvements in the banking system should expand economic opportunities to lower-wealth individuals. In this way, better-functioning banks would disproportionately benefit lower-wealth individuals. Second, by enhancing the quality of financial services, better-functioning banks will naturally benefit heavy users of financial services, which are primarily wealthy families and large firms. In this way, improvements in a country’s banking system might disproportionately help the rich. Finally, finance can also affect the distribution of income through its effects on labor markets. For example, improvements in the banking system that boost the demand for low-skilled workers will tend to tighten the distribution of income while improvements in the banking system that increase the relative demand for high-skilled workers will tend to widen the distribution of income.
As another example of how the banking system influences the distribution of income through its effects on labor markets, consider how banks shape the economic dynamism of a country. Banking systems that foster entrepreneurship increase the probability that workers will look for jobs in a dynamic, growing economy rather than in a more stagnant economy in which a few, large enterprises dominate the demand for labor.
Figure 2 illustrates that countries with better-developed financial systems tend to experience reductions in income inequality, as shown by the growth rate of the Gini coefficient of income inequality, which measures the difference between the actual distribution of income and the distribution that would exist if everyone received the same income. The Gini coefficient has a key shortcoming. Inequality per se is not necessarily an accurate indicator of prosperity. If everyone is much better off than they were but the rich are much, much better off, then simply showing that inequality rose misses the point that everyone is better off.
Even with this drawback, Figure 2 shows that when controlling for the economy’s aggregate growth rate and the level of overall economic development, as well as an array of other country-specific characteristics, greater banking system development is associated with reductions in income inequality. The evidence is consistent with the view that improvements in a country’s banking system will tighten the distribution of income above and beyond any effect of banks on the level or growth rate of economic development.
Figure 3 shows that better-developed banks, as measured by larger values of private credit, disproportionately boost the incomes of those at the lower end of the distribution of income, including the incomes of the extremely poor. As illustrated in Figure 3, private credit boosts the income growth of the poorest quintile, even after controlling for many other country characteristics, including the rate of economic growth and the level of economic development. It’s not just that finance accelerates economic growth, which trickles down to the poor; finance exerts a disproportionately positive influence on lower-income individuals.
U.S. Evidence on Finance and the Poor
The U.S. provides a unique setting in which to examine further the causal impact of improvements in the quality of banking services on economic growth, the distribution of income, and the poor. From the mid-1970s to the mid-1990s, individual U.S. states removed regulatory restrictions on opening bank branches within their boundaries. States changed their regulatory policies in different years. The reforms intensified competition and triggered improvements in banking services, reducing interest rates on loans, raising them on deposits, lowering overhead costs, spurring the development of better techniques for screening and monitoring firms, and reducing the proportion of bad loans on the books of banks.
The driving forces behind the financial reforms that enhanced the quality of financial services were largely independent of state-specific changes in growth, income inequality, and labor market conditions. Technological, legal, and financial innovations diminished the economic and political power of banks benefiting from geographic restrictions on banking. The invention of automatic teller machines (ATMs), in conjunction with court rulings that ATMs are not bank branches, weakened the geographical bond between customers and banks. Furthermore, checkable money market mutual funds facilitated banking by mail and telephone, which weakened local bank monopolies. And improvements in credit scoring techniques, information processing, and telecommunications reduced the informational advantages of local banks. These innovations reduced the monopoly power of local banks and therefore weakened their ability and desire to fight for the maintenance of these restrictions on competition. State by state, the authorities removed these restrictions over the last quarter of the 20th century.
To examine the impact of these deregulation-induced improvements in banking systems on economic growth, I build on the work by Jayaratne and Strahan and trace out the year-by-year effects of the removal of geographic restrictions on intrastate bank branching on the logarithm of gross state product (GSP) per capita. I plot GSP during the decade before a state deregulated and then plot what happened after a state removed restrictions on competition. GSP in each year is measured relative to GSP in the year of deregulation. In Figure 4, the year of deregulation is set equal to zero for all states, so that -1 is one year before deregulation and +2 is two years after deregulation. The calendar year of deregulation differs across states because they deregulated in different years. Figure 4 plots the results and the 95% confidence intervals, to get a sense of how much confidence we should have in these plots.
Figure 4 illustrates that the removal of geographic restrictions on intrastate branching — which improved the quality of banking services — boosted economic growth. There is a significant increase in GSP immediately after deregulation, and this impact grows over time. It’s worth emphasizing that these analyses are done relative to everything going on over time in the country and relative to the situation in each state. Thus, the increase in growth in the years after a state deregulates occurs relative to any changes in the overall growth rate of the U.S. economy in those years and relative to the average growth rate of the deregulating state during the sample period.
As shown in Figure 5, the improvements in banking triggered by the deregulation of intrastate branching also reduced income inequality. After controlling for national factors influencing income inequality (i.e., time fixed effects) and after controlling differences across states (i.e., state fixed effects), Figure 5 shows that inequality in a state fell materially after the state deregulated. In the average state, the Gini coefficient falls by almost 4% following deregulation relative to the change in inequality in the overall U.S. economy.
Although income inequality in the United States is growing over this period, the results in Figure 5 indicate that when a state improved its banking system, this materially counteracted this effect. Better banking exerted a dampening effect on the growth in income inequality.
Did inequality fall because the rich grew poorer or because the poor became richer? The Gini coefficient measures the deviation between an economy’s actual distribution of income and the “perfectly equal” distribution where everyone receives the same income. Thus, reductions in the Gini coefficient can happen for many reasons, including simply by reducing the incomes of higher-income people.
Figure 6 shows that in response to regulatory reforms that improved the banking sector, income inequality fell because the poor grew richer — better banks disproportionately helped those at the lower end of the income distribution. In particular, the figure examines the impact of branch deregulation on the incomes of the lowest 5% of income earners, the next 5% of income earnings, the next percentile, and all the way up to the highest 5% of income earners. For each of these groups of income earners, the figure shows how much their incomes grew in response to the regulatory reforms that boosted the banking systems in the U.S. states. The dark bars in the figure show that the result is statistically significant. The lighter-colored bars indicate that the results are too imprecisely estimated to have much confidence in the estimated impact on earnings. In this way, Figure 6 illustrates what happened to the incomes of people across the full distribution of incomes. The picture is clear. Bank deregulation increased the incomes of the poorest 35% of the population and did not have an appreciable effect on the others.
Putting It Together
Whether it’s evidence from around the world or across the United States, a considerable body of evidence suggests better-developed banks and banks freed from regulatory restrictions on competition tend to accelerate economic growth. Across many different types of studies reviewed in Levine, the evidence suggests that when banks effectively mobilize savings from disparate savers, screen borrowers and allocate capital to the most promising endeavors, monitor and govern the use of that capital, and provide mechanisms for individuals and firms to manage risk, this improves the allocation of resources with positive ramifications on the long-run growth rate of GDP per capita.
Moreover, the impact of banks on economic prosperity goes beyond aggregate growth. A growing body of evidence also shows that better-functioning banks don’t increase inequality and don’t simply help the rich. In fact, the evidence points in the opposite direction.
From both cross-country studies that use private credit as a proxy for better-functioning banking systems and U.S.-based studies that use the timing of regulations that boosted the efficiency of credit allocation to proxy for improvements in the functioning of state banking systems, the evidence is unambiguous: Better-functioning banks reduce inequality by boosting the incomes of lower-income households. It is not just that better banks also help the poor. Better banking systems disproportionately help lower-income households.
Research also tells us how this works. Improvements in banking systems facilitate creative destruction. They allow new businesses to emerge and grow, forcing less-efficient businesses to shut down. With better banking systems, there is more business entry — and exit — with little effect on the total number of businesses. It’s not that better banking systems increase the number of entrepreneurs; rather, they increase the quality of entrepreneurs by helping the market weed out the bad ones and providing the resources for the most promising ones to succeed. The more dynamic economy that emerges in response to a better banking system improves the labor market in which workers search for jobs. It is through the improved labor market that better banks primarily help the poor.