Regional Profit Rates of National Banks and the Development of the U.S. Financial Market, 1870-1914

Abstract

Lance Davis, Richard Sylla, and John James have argued that competitive forces in U.S. banking changed in the period after 1885 and this influenced loan rates charged to bank customers. Davis's original research and others that followed largely depended on interest rates as indicators of the integration of banking markets. But as Larry Neal has argued, measuring capital market integration based on interest rates on loans is complicated by factors such as local regulations, risk and duration of loans, and monopoly rents. To investigate the Davis-Sylla-James (DSJ) hypothesis, I therefore examine regional profit rates of national banks, which are more relevant to the industrial dynamics of banking. I apply both time-series and regression techniques, and find support for the DSJ hypothesis: regional profit rate differentials were large in the 1870-1884 period, but fell substantially after 1884. I also examine the relation between profit premia and financial risk and find that differences in financial risk can completely explain away profit premia for the 1885-1899 period but not for the 1870-1884 and 1900-1915 periods. This is somewhat consistent with the DSJ hypothesis, which implies that extraordinary profits existed in the 1870-1884 period but disappeared afterwards. Why a risk premium reappeared in the 1900-1914 period, however, is a puzzle. I argue that it may have been due to easing of entry barriers for national banks in 1900 that allowed a flood of new, smaller banks that, by historical standards, had low capitalization rates. By comparison with the previous period, banks in the 1900-14 period were more financially fragile and so commanded a higher risk premium. If this interpretation is correct, then the pattern of development of banking in the U.S. from 1863 to 1914 is one of a relatively mature industry responding to economic expansion and competitive forces but punctuated by exogenous regulatory changes that influenced interest rates, profits, and financial risk.