DP6029 | Finance and Efficiency: Do Bank Branching Regulations Matter?

Publication Date

21/01/2007

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Abstract

We use portfolio theory to quantify the efficiency of state-level sectoral patterns of production in the United States. On the basis of observed growth in sectoral value added output, we calculate for each state the efficient frontier for investments in the real economy, the efficient Sharpe ratio, and the corresponding weights on investments in different industries. We study how rapidly different states converge to an efficient allocation, depending on access to finance. We find that convergence is faster - in terms of distance to the efficient frontier and improving Sharpe ratios - following intra- and (particularly) interstate liberalization of bank branching restrictions. This effect arises primarily from convergence in the volatility of state output growth, rather than in its average. The realized industry shares of output also converge faster to their efficient counterparts following liberalization, particularly for industries that are characterized by young, small and external finance dependent firms. Convergence is also faster for states that have a larger share of constrained industries, greater distance from the efficient frontier before liberalization and larger geographical area. These effects are robust to industries integrating across states and the endogeneity of liberalization dates. Overall, our results suggest that financial development has important consequences for the efficiency and specialization (or diversification) of investments, in a manner that depends crucially on the variance-covariance properties of investment returns, rather than on their average only.