Deregulation of Bank Entry and Bank Failures

Abstract

Does bank deregulation enhance bank stability or exacerbate bank fragility? Consensus about the answers to this question remain elusive as theoretical and empirical studies arrive at disparate conclusions. We utilize the natural experiment offered by banking deregulation at the state level in the U.S. to examine this question. We find strong evidence that deregulation enhances bank stability by lowering bank failures. Intra-state deregulation lowers bank failures–primarily in the sixteen unit-banking states–by generating benefits from portfolio diversification, operating efficiencies and reduced loan losses. In contrast, inter-state deregulation had no effect on bank failures. Pre-existing bank failures in a state did not determine its timing of deregulation, which assures against reverse causal effects. In falsification tests, we find no effect of the deregulation on thrift failures. Our results have important implications for the regulation of the banking sector.