Disclosure Regulation in the Commercial Banking Industry: Lessons from the National Banking Era

In the aftermath of the 2007—2009 financial crisis, policymakers around the globe responded to calls for greater transparency in the financial system by adopting new rules and institutions that required more and better information disclosure by financial institutions. For example, the Dodd-Frank Act required the Federal Reserve Board to publish the results of periodic stress tests administered to the largest financial institutions. In spite of the recent flurry of regulations, the jury is still out on whether they enhance the stability and development of the financial system.

The lack of consensus is largely based on conflicting predictions from the theoretical literature. Proponents stress that disclosure and transparency regulations induce bank officers to disclose more and better information that market participants and bank stakeholders use to monitor and discipline the activities of the bank. Opponents argue, however, that disclosure and transparency regulations could force bank officers to disclose information that triggers panic-based bank runs. Thus, whether such requirements foster financial stability and development is, ultimately, an empirical exercise.

The main empirical challenge is to find a credible counterfactual evolution of the financial system in the absence of disclosure regulations. Too often, causality runs in both directions as policymakers react to crises by adopting new legislation. It is, thus, difficult to distinguish whether regulations affect stability or are simply associated with stability because they are adopted in the aftermath of banking crises. My empirical design addresses this issue by exploiting variation in the adoption of disclosure and supervisory regulations for state-chartered banks during the period that became known as the National Banking Era. From the passage of the National Banking Act in 1863 until the creation of the Federal Reserve system in 1914, state lawmakers expanded disclosure and micro-prudential supervisory standards at different times by requiring commercial banks under their jurisdiction to publish periodic reports of financial condition in local newspapers and by implementing periodic on-site examinations of state banks.

This historical setting overcomes some of the challenges associated with estimating the effects of disclosure and supervisory regulations. State lawmakers passed these regulations at different times, thereby mitigating concerns that concurrent macroeconomic events drive the empirical results. Moreover, these state regulations only affected commercial banks operating under a state charter. I exploit this feature by comparing the outcomes of state-chartered banks with the outcomes of federal-chartered banks that operated in the same states and were subject to similar local economic shocks but were not directly affected by the adoption of state disclosure and supervisory regulations. The evolution of national banks, therefore, is a proxy for the counterfactual evolution of state banks operating in the same state.

The empirical results are consistent with the idea that disclosure regulations reduce instability in the banking system. The adoption of those regulations by state lawmakers is associated with a reduction in the failure rate of state banks by approximately two percentage points. By contrast, the adoption of periodic on-site examination requirements does not significantly affect this failure rate. Such results suggest that the long-run benefits of improving market monitoring of financial institutions outweigh the potential destabilizing effects of disclosure regulation.

I also examine the impact of disclosure and supervisory regulations on financial development, measured as access to credit and availability of banking services. The idea is to empirically assess an important theory advanced by University of Chicago professors Raghuram Rajan and Luigi Zingales, who have suggested that accounting and disclosure systems that promote transparency are cornerstones of developed financial systems. The conceptual underpinning of their hypothesis is that when accounting systems are strong and transparent, depositors and other market participants find it easier to rely less on the reputation of well-established bankers and are more willing to trust less established and younger bankers. Transparent accounting systems, therefore, facilitate entry, reduce rents of incumbents, and increase competition in the banking industry. Consistent with this idea, I find that the adoption of disclosure regulations have a positive effect on two measures of access to credit: the total number of banks per capita in the state and the average interest rate on loans.

It is difficult to reconcile the positive effects of disclosure regulation with its late adoption in some states. Such positive effects suggest that state lawmakers could improve welfare of their constituents by adopting these regulations earlier. In the last part of the study, I investigate potential causes of the significant variation in the timing of adoption. Specifically, I ask whether two powerful classes, large landowners and incumbent financiers, with a vested interest in reducing competition in the banking system are associated with delays in adoption. The idea is that these classes enjoy strong reputations and would see their ability to extract rents from local populations diminished by the passage of regulations that promote transparency.

I use two empirical strategies to investigate whether these constituencies are associated with the timing of adoption of these regulations. First, I model the timing of adoption in each state to examine whether the strength of large landowners affected that timing. Second, I examine whether these classes influenced the outcomes of the 1888 Illinois and Michigan referenda of the state banking law amendments requiring periodic examinations of state banks. I find that states with large, powerful landowners and states with a large share of small private bankers adopt disclosure and supervisory regulations later. I also find that support for the banking law amendments was weaker in counties of Illinois and Michigan with stronger landowners and bankers.

Overall, my study examines the adoption of disclosure regulation in the U.S. state banking systems of the late 19th century. Understanding the lessons from history could offer useful insights into how agents react to disclosure regulations. Former governor of the Federal Reserve, Randall Kroszner, suggested in a 2010 article that during the recent financial crisis policy makers turned to Milton Friedman and Anna Schwartz’s monumental “A Monetary History of the United States” as a guide for the potential effects and unintended consequences of policy measures that were implemented during the Great Depression. The recent financial crisis revived the need to understand how disclosure and supervisory regulations affect the stability and development of the banking system. This study is an attempt to draw on the lessons of the past to bring valuable insights to this current policy debate.

This post comes to us from Professor João Granja at the University of Chicago’s Booth School of Business. It is based on his recent article, “Disclosure Regulation in the Commercial Banking Industry: Lessons from the National Banking Era,” available here.