any 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
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
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
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
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
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'
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.
"Banking Deregulation and Industry Structure: Evidence from the
French Banking Reforms of 1985." Marianne Bertrand, Antoinette
Schoar, and David Thesmar.