The Role Banking Deregulation Plays in Economic Booms and Busts
Following the global uncertainty unleashed at the end of World War II, many nations imposed “credit ceilings” which limited the growth of bank loans as a way of controlling the money supply and inflation.
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However, the global economy evolved, and banking deregulation became more prevalent in the 1970s and 1980s and the removal of credit ceilings for financial institutions became commonplace. Research by SDSU finance professor Isaac Green examines how these policy shifts played out, and what they meant for the broader economy.
Do financial deregulations equal a banking crisis?
Green was one of two researchers that studied the effects of the removal of bank credit ceilings among 13 advanced and emerging economies that took place between 1971 and 1990. They recently co-authored their findings in the Journal of Financial and Quantitative Analysis, where they discussed how deregulation initially led “to a rapid increase in the growth of bank credit.”
“Within three years of removing the credit ceilings, bank lending in affected categories rose sharply, trending upward in a nearly 30% growth spurt,” said Green. “This credit surge helped to drive investment, housing prices and bank stock prices.”
But what goes up must ultimately come down.
Boom to Bust
While credit levels surged, the overall economic output (gross domestic product or GDP) did not. In fact, the researchers discovered that within four to 10 years of the initial surge, the economic growth reversed itself, leading to a banking crisis in 11 of the 13 countries studied.
The researchers noted that removal of the credit ceilings were the most likely culprit for the boom-and-bust impact on the economy. They reached these conclusions due to the consistently short time lag between the loosening of credit ceilings and credit growth; the fact that other deregulation measures tended to have lesser effects on credit growth; and that the credit ceilings were typically removed or loosened for political purposes as opposed to economic factors. These drivers make it more likely that policy makers did not anticipate their effect on financial stability.
Once credit controls were gone, there was no turning back. The vast expansion of bank credit made reimposing credit controls on financial institutions impossible, as five nations within the study attempted to do. In fact, credit expansion continued even as governments tried to reassert limitations, leading to a banking crisis in all five nations within five years of reimposing ceilings.
In conclusion
The researchers related their findings to previous studies of financial deregulation in the United States, which showed that removals of predatory lending laws and bank branching restrictions also coincided with boom-and-bust cycles.
“Given these historical examples, we sought to determine whether financial deregulations amplify existing fragilities, or if they can initiate national boom-and-bust cycles on their own,” said Green. “Our analysis suggests the latter.”
