Raghuram Rajan

1. Baffi Lecture 2013Financial development: Lessons from American Banking in the Early 20th Century Raghuram Rajan

2. 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.

3. 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

4. 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

5. 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)

6. 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?

7. 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.

8. Banks per capita and land concentration

9. 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?

10. 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.

11. 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”

12. 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

13. 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.

14. 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.

15. Data Land prices • US Census 2600 counties, 1910, 1920, 1930, self reported. Bank data • Measure credit availability based on proximity/bank density • Number of banks in county • Banks per area in county • Banks per capita in county

16. 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

17. 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.

18. Land Prices and Credit Availability

19. 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.

20. Distance and borders • Banks could not lend across state lines 100 50 0 50 A B C D • Proximity likely mattered for lending

21. Borders, Banks and Land Prices

22. 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.

23. Land Price Residual, Banks and Commodity Index

24. 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.

25. Banking Distress 1920-1929, Banks and Commodity Index

26. 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.

27. The Evolution of Land Prices, Banks and Commodity Index

28. 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”.

29. 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.

30. 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.

31. 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.