Deregulation of Bank Entry and Bank Failures

The financial crisis of 2008 highlighted the debilitating effect that a disruption in the banking sector can have on the macro-economy. Not surprisingly, therefore, preserving banking sector stability has occupied center stage in regulatory and policy-making circles. As well, the popular narrative describes the crisis as an outcome, at least partially, of increased deregulation of the banking sector over the last two decades. In this context, an important question arises: does deregulation lead to instability in the banking sector? In this overarching theme, in this paper, we examine the effect of the deregulation of bank entry on bank stability.

In theory, the effect of the deregulation of bank entry on bank stability is ambiguous. On the one hand, theoretical models provide opposing predictions about the effect of bank competition on the stability of banks. On the other hand, deregulation of bank entry may result simultaneously in greater competition in the local banking market as well as greater consolidation among banks in the economy. Therefore, this question has to be answered empirically. Using the staggered deregulation of entry restrictions by U.S. states, we find that deregulation of bank entry enhances bank stability by lowering instances of bank failures. Consistent with the effects being strongest in environments where the structure of banking markets changed the most, the effects are mainly due to intra-state deregulation and in states that had unit banking laws. In falsification tests, we find no effect of the deregulation on thrift failures. Furthermore, pre-existing bank failures in a state did not determine its timing of deregulation, which assures against any reverse causal effects. The reduction in bank failures seemed to result from benefits from greater geographic diversification, and banks becoming more efficient post-deregulation.