Baffi Lecture 2013
Financial 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?
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

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.
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Plan for the talk

Why is financial history important?


Outline theories of financial development

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Explain what light our findings shed on them.
Study one consequence of easier access to
credit.

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
American banking in the early 20th century is
especially illuminating.
Land prices in the agricultural boom and bust
Impact on banks
Relate back to lessons for today
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Why history?

History repeats but also its consequences
persist
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Hysteresis
Can tease out economic forces
Natural experiments with useful
identification

American banking in the early 20th century
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Importance of agriculture
Local markets – proximity important
Regulations as identification
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Theories of financial
development

Colonial origin

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Colonialism and coercive political institutions


LLSV (1997, 98)
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)
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Technology of production and
constituencies

Plantation agriculture => more concentrated
land holdings => more concentrated wealth
=> stronger desire to control finance.

Extract rents through other means


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Preserve access for themselves

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Sale of inputs (Ransom and Sutch (2001))
Fire sales of land
Cheap labor (Galor et al. 2006)
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)


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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?
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Rajan and Ramcharan (2012 a)
“Constituencies and Legislation: The Fight
over the McFadden Act of 1927”


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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
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But can we have too much finance?

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E.g., Rajan and Zingales (1998)
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”
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Findings

Does access to finance affect asset prices in the
face of an exogenous shock to fundamentals?
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How does it work?
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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
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.
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Credit Market developments

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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.
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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
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.
Land Prices and Credit Availability
VARIABLES
log number of banks
Dependent Variable: Log Land Price Per Acre
(1)
(2)
(3)
OLS
IV
1900-1920
county and year fixed
effects
0.0925**
(0.0373)
log number of banks, 1910
0.277***
(0.0379)
log number of banks, 1920
0.587***
(0.0775)
Observations
R-squared
8,137
0.954
2,478
0.742
2,464
0.752
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
Borders, Banks and Land Prices
(1)
VARIABLES
log number of banks, 1920
Dependent
Variable: Log
Price Per Acre
in 1920,
Census
100 mile
window
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)
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
Commodity Index Shock, 1917-1920
Quartiles
2
Quartiles
Banks 1920, (log)
1
3
4
1
2
3
4
Mean
Std. Dev
-0.007
-0.033
-0.081
-0.023
Obs
0.290
0.211
0.198
0.243
244
211
109
91
Mean
Std. Dev
0.006
-0.029
0.018
0.039
Obs
0.274
0.228
0.198
0.225
191
180
163
128
Mean
Std. Dev
-0.036
-0.003
-0.005
0.086
Obs
0.282
0.194
0.174
0.219
118
134
198
182
Mean
Std. Dev
-0.017
-0.047
0.014
0.042
Obs
0.261
0.191
0.177
0.184
64
101
157
229
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.
Banking Distress 1920-1929, Banks and Commodity Index
VARIABLES
(1)
(2)
Bank Suspension Rate, 19201929
(3)
(4)
Deposits Suspension Rate,
1920-1929
OLS
0.0269***
(0.00510)
IV
0.0171*
(0.00973)
OLS
0.0198***
(0.00433)
IV
0.0197**
(0.00813)
log banks, 1920, squared
-0.00410***
(0.00120)
-0.00334
(0.00214)
-0.00192*
(0.00110)
-0.00286
(0.00175)
Commodity Index, 19171920
-6.24e-05
-6.07e-05
-0.000682
1.94e-05
(0.000462)
(0.000699)
(0.000556)
(0.000594)
0.000782
0.000951
0.00197
0.000235
(0.00108)
(0.00172)
(0.00152)
(0.00156)
2,477
0.396
2,447
0.395
2,474
0.339
2,446
0.341
log banks, 1920
Commodity index* log
banks, 1920
Observations
R-squared
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.
The Evolution of Land Prices, Banks and Commodity Index
VARIABLES
(1)
Log Price
Per Acre,
1920
(2)
Log Price
Per Acre,
1930
(3)
Log Price
Per Acre,
1940
(4)
Log Price
Per Acre,
1950
(5)
Log Price
Per Acre,
1960
-0.722***
(0.146)
-0.331***
(0.105)
log banks, 1920
0.205**
(0.0820)
-0.104
(0.0710)
IV
-0.386***
(0.0859)
log banks, 1920,
squared
-0.0585***
-0.0154
0.0408
0.130***
0.0441
(0.0185)
(0.0225)
(0.0267)
(0.0312)
(0.0288)
0.0147**
0.0223***
0.0197*
0.0185
0.00878
(0.00682)
(0.00788)
(0.0103)
(0.0134)
(0.0118)
-0.00264
-0.0903***
-0.104***
-0.0405
-0.0283
(0.0184)
(0.0238)
(0.0253)
(0.0375)
(0.0340)
2,454
0.928
2,454
0.874
2,453
0.836
2,454
0.747
2,454
0.777
Commodity Index,
1917-1920
Commodity index*
log banks, 1920
Observations
R-squared
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.
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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.
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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.
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