DP6202 Finance and Efficiency: Do Bank Branching Regulations Matter?

Author(s): Viral V. Acharya , Jean Imbs , Jason Sturgess

Publication Date: March 2007

Keyword(s): Diversification , Financial Development , Growth , Sharpe Ratio , Volatility

JEL(s): E44 , F02 , F36 , G11 , G21 , G28 , O16

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6202.asp.asp

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. We study how rapidly different states converge to this benchmark 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 and greater distance from the efficient frontier before liberalization. These effects are robust to industries integrating across states and to the endogeneity of liberalization dates. Overall, our results suggest that financial development has important consequences for 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.