Impact of Financial Structure on Industrial Structure: Evidence from Timing of Interstate Deregulation in U.S.

In this paper we posit and empirically demonstrate that the structure of a economy's financial system impacts its industry structure through its influence on the allocation of credit to firms within and across industries. We exploit variation in domestic banks' ability to compete with out-of-state entrants at the time of interstate deregulation across U.S. states to generate significant changes to the structure of financial system - market share of out-of-state banks - in an economy. We then use within-state, cross-sectional variation at the bank level, at the industry level, and at the firm level to test our hypothesis. Following deregulation, arm's length out-of-state capital crowds out domestic lending in economies with weak domestic banking sector. In contrast, there is an increase in the aggregate supply of credit in economies with more competitive domestic banks. We show that these differential changes in financial structure significantly affect the allocation of credit. There is a higher growth rate and lower growth volatility for industry sectors in economies with more competitive domestic banks. These results are driven by more credit owing to industries that are reliant on external financing and to opaque firms. In contrast, industry growth is lower and growth volatility is higher in economies with uncompetitive domestic banks. These results are driven by less credit ow to more externally finance dependent industries and opaque firms. Thus, the timing of deregulation of credit markets interacts with the development of the incumbent domestic banking sector, and the change in financial structure it induces has implications on the allocation of credit and economic growth.