BENEFITS OF BANKING COMPETITION: Evidence from the UK’s 1971 reform

06 Feb 2019

Increased competition in the banking sector has significant positive effects on firms, allowing them to undertake more investment and substitute expensive trade credit with bank debt. That is the central finding of research by Fabio Braggion and Steven Ongena, which examines the impact of the UK’s 1971 deregulation of the banking sector on firms’ financing and investment decisions.

 

Their study, which is published in the February 2019 issue of The Economic Journal has policy implications for emerging economies such as China, which have a concentrated banking sector, credit controls and interest ceilings similar to those in place in the pre-1971 UK. Banking liberalisation can have a considerable impact on corporate finance and the real economy.

 

The researchers note that since the 1970s, a number of countries have deregulated their banking systems and abandoned the strict rules that governed financial institutions since the Great Depression. Deregulation was intended to increase competition in the credit market and improve consumers’ welfare, but many observers have argued that it lay at the root of the 2008 financial crisis.

 

Despite substantial interest in this issue, we have limited knowledge of the effects of deregulation and increased bank competition on the real economy. Does banking deregulation have a positive effect on firms’ access to credit and investment? Or is it only a vehicle for increasing the fragility of the financial system?

 

The new study focuses on the first question, examining an important event in recent UK economic history – the 1971 deregulation of the banking sector – and relating it to firms’ financing and investment decisions.

 

The 1971 reform introduced competition into the UK banking market by removing interest rate limits on both loans and deposits, and by eliminating other cartel agreements (such as uniform opening hours and administrative charges applied to customers) that had characterised the UK banking sector since 1948.

 

This reform is an attractive focus for studying competition, banks’ activities and firms’ financing for two reasons. First, it was introduced very quickly; and second, it was only concerned with increasing competition in the banking sector, and it did not involve other aspects of the economy, as did similar reforms in continental Europe.

 

The researchers first give a sense of the significance of the reform, documenting that for more than 80 years (since reliable data have been available), firms established a business relationship with only one bank. From 1971, there was a remarkable shift from bilateral to multilateral relationship banking.

 

About 85% of UK companies in the study’s sample were involved in a single bank relationship between 1906 and 1970. That proportion had declined to 72% in 1976 and 64% in 1986. This result shows that after the reform, firms were freer to bank with more credit institutions, and those institutions worked harder to attract customers.

 

The researchers then study in depth the effects of the banking sector deregulation on firms’ financing. The immediate effect of deregulation (increasing competition) should be stronger in cities with less concentrated banking markets, where many banks already had multiple branches. In these cities, banks could start competing immediately after the introduction of the reform, compared with cities with fewer banks and fewer branches, where banks could start to compete only after setting up new branches.

 

The analysis finds that following deregulation, firms in less concentrated markets increased their number of bank relationships, their reliance on bank debt and their leverage. They also decreased trade credit considerably, while at the same time increasing their investment in intangible assets.

 

For example, a change in the concentration index from monopoly to perfect competition increases the number of bank relationships by 10%, bank debt over total debt by 45% and leverage by 13%. The effects are stronger for younger firms and firms especially engaged in R&D.

 

These results suggest that more competition in the banking sector has positive spillovers for firms. It allows them to undertake more investment and substitute expensive trade credit with bank debt. The authors conclude:

 

‘We believe that our analysis has important policy implications. Emerging economies such as China have, today, a concentrated banking sector, credit controls and interest ceilings similar to those in place in the pre-1971 UK.’

 

‘The UK experience provides useful guidance on the effects of banking liberalisation on corporate finance and the real economy.’

 

Banking Sector Deregulation, Bank-Firm Relationships and Corporate Leverage’ by Fabio Braggion and Steven Ongena is published in the February 2019 issue of The Economic Journal.

 

Fabio Braggion

Tilburg University | F.Braggion@uvt.nl

Steven Ongena

University of Zurich | steven.ongena@bf.uzh.ch