Motives and Consequences Of Financial Regulation

The motives and consequences of financial regulation are once again being hotly debated in the current global financial crisis. However, this debate is hardly new. In my paper The Political Economy of Financial Regulation: Evidence from U.S. State Usury Laws in the 19th Century, which was co-written with Tobias Moskowitz of the University of Chicago and which was recently accepted for publication in the Journal of Finance, we look to the past and study the political economy of financial regulation and its consequences through the lens of usury laws in 19th century America. Usury laws are arguably the oldest form of financial regulation. Moreover, the rich political and economic landscape of the 19th century United States provides a useful laboratory to investigate the motives and impact of financial regulation during a critical point of U.S. economic development. Our investigation into the causes and consequences of financial regulation entails answering who and what determines regulation and who benefits and loses from it.

We first argue that usury laws had financial and economic impact. We show that binding rate ceilings constrain some borrowers at certain times and that usury laws significantly affect lending activity in the state. We further show that changes in these laws are associated with future economic growth and, importantly, that the impact on growth is concentrated exclusively among the smallest borrowers in the economy.

We then investigate the determinants of financial regulation. Like everything, use of regulation varies with its cost. States impose tighter usury laws (lower maximum rates and stiffer penalties) when it is less costly to do so. When current market interest rates exceed the rate ceiling or during financial crises, states relax restrictions by raising the rate ceiling. When market rates fall or the crisis abates, ceilings are re-imposed or tightened. States hit hardest by financial crises are even more likely to follow this pattern. We also show that usury laws respond to neighboring state competition for capital flows (particularly foreign at this time). These results suggest that usury laws have real (or at least perceived) impact, otherwise why bother to change them?

To distinguish between the private and public interest motives for regulation we measure the extent of incumbent political power in a state and its relation to usury laws. State suffrage laws that restrict who can vote based on land ownership and tax payments (not race or gender) keep political power in the hands of wealthy incumbents. We find that such wealth-based voting restrictions are highly correlated with financial restrictions. We find that wealth-based suffrage laws are not affected by financial crises. We also find that after a financial crisis abates, states with stronger wealth-based voting restrictions are even more likely to re-impose tighter usury laws.

As further corroboration of private interests, we find a positive relation between wealth-based suffrage restrictions and other forms of economic regulation designed to exclude certain groups, such as general incorporation laws that permit free entry of firms. In addition, we find that usury laws are tighter when incorporation restrictions are also tight, which seems to conflict with the public-interest motivation, which is supposed to include or help underserved or disadvantaged groups rather than limit access. We also consider whose private interests, the financial or non-financial sector, are best being served by these policies and find that the combination of policies most correlated with usury laws fits non-financial incumbent interests best.

Overall, the evidence we uncover appears most consistent with financial regulation being used by incumbents with political power for their own private interests—controlling entry and competition while lowering their own cost of capital.

The full paper is available for download here.