Schumpeter’s Hand

Drastically reducing government intervention in banks' lending decisions can lead to a better allocation of credit and faster economic growth.

Many economists have consistently found a strong link between a well-developed financial market and robust economic growth. This suggests that liberalizing a heavily regulated banking system is one way to fuel growth. However, there is a limited understanding about how this relationship works. How would removing government intervention in bank lending decisions lead to a change in firm behavior as well as the structure and dynamics of industries?

The idea of "creative destruction" first noted by economist Joseph Schumpeter plays an important role in this process, according to a study titled "Banking Deregulation and Industry Structure: Evidence from the French Banking Reforms of 1985" by University of Chicago Booth School of Business professor Marianne Bertrand, Antoinette Schoar of the Massachusetts Institute of Technology, and David Thesmar of HEC Paris.

In a deregulated banking system, banks are less willing to provide loans to poorly performing firms, many of which may eventually be forced to close without the help of subsidized loans. In addition, new companies will find it more attractive to enter the market if they know that incumbent firms no longer have easy access to cheap credit. In this competitive environment, a higher rate of entry and exit of companies allows credit to be distributed more efficiently across firms, which, in turn, leads to faster growth.

The deregulation of the French banking industry in 1985 abolished subsidized loans almost entirely and gave banks the freedom to decide which companies to lend to and how much to charge. Competition between banks provided the incentive to sharpen their screening and monitoring practices so that only credit-worthy firms were given loans. Indeed, the study by Bertrand and her co-authors finds that after the reforms, French banks put more emphasis on the credit quality of borrowers when determining loan size and interest rates.

Moreover, companies that belonged to more bank-dependent industries prior to the reform engaged in more cost-cutting and restructuring after deregulation in order to improve their credit rating. Many more firms entered and left the market, especially in industries that relied heavily on bank loans. Stricter lending seems to force underperforming firms to shut down, allowing bank capital to be allocated to its most productive use.

The French Banking Deregulation of 1985

The scope of banking regulations in France prior to 1985 matches the experience of many other countries with government- controlled banks. Thus, the country's experience with deregulation also is a good example of the many changes other countries would have to implement to liberalize their financial sector.

Prior to deregulation, the French government's Treasury department controlled the credit market through a network of banks that provided subsidized loans to priority industries. The 1976 "encadrement du crédit" program, in particular, further strengthened the importance of subsidized loans and government control over lending decisions. Under the program, a monthly ceiling on credit growth was imposed on banks that did not belong to the Treasury's network because the government was unwilling to raise interest rates at a time when the value of the French franc was slipping. Meanwhile, banks that were part of the network continued to supply subsidized credit without limit.

By the early 1980s, the number of subsidized loan programs increased dramatically to about 250 as the Treasury continued to focus intensely on preserving jobs. The credit market became even more opaque, supporting different interest rates for different loan programs. Banks were accumulating more and more non-performing loans. The French banking industry was so heavily regulated that interest rates played almost no role in the allocation of capital. The "encadrement du crédit" and the subsidized loans system had also become too costly to manage. By 1984, it was clear that the French government had to drastically reverse its policies.

The 1985 reform was the start of the financial system's transformation into a decentralized credit market where subsidized loans would be gradually eliminated and interest rates would be used to match the supply and demand for capital. The banking industry became more transparent and conducive to competition.

A striking result is that the country's ratio of total debt to assets dropped from around 70 percent in the early 1980s to around 50 percent just two years after deregulation and stayed at that level over the next 10 years. Half of this decrease in leverage was due to a reduction in bank loans.

Another widely noted consequence of the reform was the change in the way banks do business. The new business environment forced banks to change their lending practices and restructure internally. One survey found that bank managers paid more attention to reducing costs, controlling risks, and introducing tighter performance monitoring. The competitive pressure was felt most by banks that had privileged access to deposits and loan markets under the old regime; their share of all deposits and loans fell by about 25 percent.

Firms' Capital Structure and Banks' Lending Practices

Firms in industries that relied heavily on bank financing before the reforms would likely be most affected by the change in policies because these firms were more exposed to distorted lending practices. Thus, to fully understand the impact of liberalizing the credit market, the authors looked at the way a typical firm that depended heavily on subsidized loans was affected by deregulation and compared the experience to that of another firm belonging to a less bank-dependent industry.

In terms of capital structure, the study finds that companies in bank-dependent industries experienced a sharper reduction in bank debt compared to other firms that relied less on loans from banks. The fall in bank credit is only partly compensated by financing raised from equity. To fill the gap, firms in bank-dependent industries increasingly turned to trade credit, or credit extended by suppliers, after deregulation. The reduction in debt also is especially pronounced among the worst-performing firms, which is expected if banks had truly become more selective after deregulation.

Because the cost of capital during that period was relatively high—real interest rates rose in the mid-1980s—the shift in capital structure may have been due to companies deciding to take on less bank debt rather than an improvement in banks' screening procedures.

The study's results indicate otherwise. Firms that experienced a sudden drop in performance had more difficulty raising debt after deregulation, particularly in bank-dependent industries, which suggests that banks were less willing to bail out poorly performing firms. Moreover, banks seemed to effectively screen out firms that were structurally weaker while continuing to extend credit to those companies that may have been going through a rough period but were fundamentally profitable in the long run.

The authors also find that firms that received new bank loans post-reform were more likely to improve their performance than those that received loans before deregulation, which again indicates that banks enhanced their screening and monitoring abilities. Thus, after deregulation, access to bank credit became more closely tied to good performance.

The Structure and Dynamics of Industries

Stricter bank lending gives companies a stronger incentive to operate more efficiently. The authors find that firms belonging to bank-dependent sectors cut wages and outsourced part of their operations much more than firms in industries that were less dependent on bank loans. Companies that were most affected by deregulation also significantly reduced their assets, suggesting that easy access to credit in the pre-reform period may have contributed to overinvestment.

An interesting result is that the firms that were doing relatively better prior to the reform improved the most after deregulation, even though one would expect that poorly performing firms faced the most pressure to restructure. This suggests that part of the real adjustment to liberalizing the credit market was at the "extensive margin," that is, weak firms eventually forced to shut down.

In fact, the study finds that after deregulation a higher fraction of assets were created and destroyed by the entry of new firms and the exit of existing ones, especially in bank-dependent industries. Poor performers were more likely to fold after the reform than in the period prior to deregulation. Good performers, on the other hand, tend to do even better. These findings are consistent with capital being withdrawn sooner from weaker firms while relatively more capital is allocated to well-run companies after deregulation.

A more efficient banking sector thus plays an important role in fostering a process of "creative destruction" that has been linked to faster economic growth. Another piece of evidence is that market concentration fell significantly after deregulation, particularly in bank-dependent industries, which is expected if the increased entry and exit of firms is indicative of a more dynamic and competitive industry structure.