THE POLITICAL ECONOMY OF FINANCIAL REGULATION: EVIDENCE FROM U.S. STATE USURY LAWS IN THE 19TH CENTURY

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1 THE POLITICAL ECONOMY OF FINANCIAL REGULATION: EVIDENCE FROM U.S. STATE USURY LAWS IN THE 19TH CENTURY Efraim Benmelech, Harvard Economics and NBER Tobias J. Moskowitz, University of Chicago GSB and NBER

2 Benmelech and Moskowitz 2 Motivation What are the causes and consequences of financial regulation? What determines financial regulation and why? Who benefits and loses from financial regulation? What is the political economy of financial regulation? Can this shed light on the economics of regulation in general? Is this a microcosm for thinking about regulation today in emerging markets?

3 Benmelech and Moskowitz 3 What We Do We examine the political economy of financial regulation through the lens of usury laws across states in the 19th century U.S. Usury laws govern the maximum interest rate on loans and the penalties imposed for violating rate ceilings. No adjustment for risk. May result in credit rationing. Location of borrower that matters. Usury laws are, arguably, the oldest form of financial regulation. Examine the determinants of usury laws and their financial and economic impact.

4 Benmelech and Moskowitz 4 Why Usury Laws? Easy to quantify: Need a policy instrument for the mechanism of regulation to be identified. Other measures of financial development (e.g., credit/gdp, market cap./gdp) can be problematic. Maximum legal rates and penalties are quantifiable and may have direct constraints on cost of capital. Within country analysis; holding legal origin and institutions somewhat fixed.

5 Benmelech and Moskowitz 5 Usury laws in the U.S. during the 19th century provide a rich setting: Substantial heterogeneity in usury laws across states and over time for a given state. Substantial heterogeneity in other regulation across states and over time. Heterogeneity in enforcement of regulation across states and time. Heterogeneity in incumbent political power across states and time. Heterogeneity in economic growth across states at this time.

6 Benmelech and Moskowitz 6 Theories of Regulation The Private Interest View Capture theory: one group uses the coercive power of the state to extract rents at the expense of others (Stigler 1971, Posner 1971, Peltzman 1976, Becker 1983). The political economy of financial development (Rajan and Zingales 2003a, 2003b). Incumbents protecting rents through economic and financial regulation. Regulation benefits incumbents directly and by impeding competition from new entrants. Whose interests are served by usury laws?

7 Benmelech and Moskowitz 7 The Public Interest View Fix market inefficiencies and promote or protect public welfare (monopoly power, externalities). Usury laws protect: A borrower from the market power of the lender. A borrower from himself. Usury laws serve as a primitive form of social insurance to more efficiently transfer wealth and smooth idiosyncratic shocks (Glaeser and Scheinkman (1998)). Do usury laws protect the poor or financially distressed, or do they reward financially strong incumbents by limiting access to others?

8 Benmelech and Moskowitz 8 Preliminaries: Usury Laws in the U.S. Date back to at least 1641 in Massachusetts. Regulated maximum rate that could be charged on loans. Set penalties for charging usurious rates. We construct a penalty index. Heterogeneity across states (Table 1). Heterogeneity across time for a given state (Table 1). Range of rate ceilings and penalties. Number of positive and negative changes.

9 Benmelech and Moskowitz 9 Table 1: Summary Statistics on Maximum Legal Interest Rate and Penalty for Usury Maximum interest rate (%) Penalty for Usury Year of Avg. Min. Max. #Changes Avg. Min. Max. #Changes Statehood State + + Virginia Delaware Maryland New Hampshire Vermont Tennessee Pennsylvania Kentucky North Carolina Ohio New Jersey New York Connecticut none Massachusetts none Alabama none Indiana none District of Columbia Georgia none South Carolina none Rhode Island none Michigan Mississippi none Missouri Illinois Maine none Arkansas none Wisconsin none Iowa none Texas none Minnesota none Louisiana none Florida none California none none none mean stdev correlation (max. rate, penalty) = 0.37 correlation ( max. rate, penalty) = 0.33

10 Benmelech and Moskowitz 10 If innocuous, why so many changes? Correlation between rate ceilings and penalties is negative a sign of enforcement. Relationship between state age and strictness of usury laws. Between variation. Within variation. Figure 1.

11 Benmelech and Moskowitz 11 Figure 1. Evolution of Average Maximum Allowable Interest Rate and Usury Penalty *1873 Crisis 4 Average Maximum Interest Rate 0.1 Penalty index *Civil War end *1884 Crisis 3 Average Penalty Index Maximum interest rate 0.08 *1857 Crisis 2 *1819 Crisis Age

12 Benmelech and Moskowitz 12 Do Usury Laws Matter? Can usury laws be effectively circumvented through clever contracting (Wright 1949)? Innovative contracting imposes additional costs. Difficult to enforce deterred lenders, particularly foreign lenders (North 1990). Banks reluctant to violate because placed corporate charter at risk (Wright 2002). Economic historians debate their significance.

13 Benmelech and Moskowitz 13 Are usury laws ever binding and enforced? Certainly matters for some groups within the state. At a minimum there is a resource transfer. Market interest rates and relation to usury rate ceiling. Are usury laws a signal of other restrictive financial and economic policies? The combination of policies has bite. Some probability usury laws bind or provide a threat. * These are empirical questions.

14 Benmelech and Moskowitz 14 Table 2: Market Interest Rates and Binding Usury Ceilings Panel A: Correlation matrix of market interest rates Principal UK US Commercial NE Railroad Call money component State bonds bonds paper municipal bonds rate index loan rate Sample begins: UK bonds US bonds CP NE municipal Railroad bonds Call money PC index

15 Benmelech and Moskowitz 15 Panel B: Frequency of Maximum legal rates below market interest rates Maximum rate < US bond Commercial paper Railroad bond Call money Sample period #years %years #years %years #years %years #months %months Virginia % % % % Delaware % % % % Maryland % % % % New Hampshire % % % % Vermont % % % % Tennessee % % % % Pennsylvania % % % % Kentucky % % % % North Carolina % % 6 4.0% % Ohio % % 9 9.7% % New Jersey 8 5.2% % 6 3.9% % New York 5 2.9% % 0 0.0% % Connecticut % % % % Massachusetts % % 7 2.8% % Alabama 8 9.2% % 0 0.0% % Indiana 3 4.1% % 7 9.5% % DC 2 4.8% % % % Georgia 0 0.0% % 0 0.0% % South Carolina 5 2.5% % 0 0.0% % Rhode Island % % 5 4.0% % Michigan 0 0.0% % 0 0.0% % Mississippi 8 9.2% % 0 0.0% 6 0.6% Missouri 0 0.0% % 0 0.0% % Illinois 0 0.0% % 0 0.0% % Maine 3 4.2% % % % Arkansas 0 0.0% % 0 0.0% 0 0.0% Wisconsin 0 0.0% 5 9.4% 0 0.0% % Iowa 0 0.0% % 0 0.0% % Texas 0 0.0% 1 1.9% 0 0.0% 0 0.0% Minnesota 0 0.0% 0 0.0% 0 0.0% 0 0.0% Louisiana 3 3.4% % 0 0.0% 9 1.0% Florida 0 0.0% % 0 0.0% 9 1.0% California 0 0.0% 0 0.0% 0 0.0% 0 0.0%

16 Benmelech and Moskowitz 16 Figure 2. Market Interest Rates and Maximum Legal Rates (1878 to 1891) Average rate ceiling Crisis * Commercial paper rate Average bank lending rate for no limit states Average bank lending rate for states with rate ceilings Minimum rate ceiling 0.08 Interest Rate Year

17 Benmelech and Moskowitz 17 Do Usury Laws Matter? Impact on enforcement and lending activity. (Table 3) Impact of usury laws on lending volume per capita. Distinguishing supply from demand effects. Impact of usury laws on other forms of financing not subject to usury laws bonds (financing substitute). Are penalties tougher when maximum rates become more binding?

18 Benmelech and Moskowitz 18 Table 3: Do Usury Laws Matter? Panel A: Impact of usury laws on lending volume Dependent variable = Loans and discounts per capita Sample period Max. rate (2.38) (Max. rate PC rate) (2.44) (Max. rate Regional rate) (2.43) (Max. rate State bank rate) (2.65) Fixed effects: Year? yes no yes yes State? yes yes yes yes R R 2 after F.E Cluster state year year year Panel B: Impact of usury laws on bonds for circulation Dependent variable = Bonds for circulation per capita Sample period Max. rate (-1.62) (Max. rate PC rate) (-1.65) (Max. rate Regional rate) (-2.41) (Max. rate State bank rate) (-1.67) Fixed effects: Year? yes no yes yes State? yes yes yes yes R R 2 after F.E Cluster state year year year

19 Benmelech and Moskowitz 19 Panel C: Are Penalties Tougher When Maximum Rates are More Binding? Dependent variable = Penalty for violating usury Sample period Max. rate (-3.34) (Max. rate PC rate) (-4.38) (Max. rate Regional rate) (-4.71) (Max. rate State bank rate) (-3.42) Fixed effects: Year? yes no yes yes State? yes yes yes yes R R 2 after F.E Cluster state year year year

20 Benmelech and Moskowitz 20 Determinants of Usury Laws Is financial regulation tighter when it is less costly? (Table 4) How do maximum rates respond to market interest rates? (Panel A) How do maximum rates respond to financial crises? (Panel B) Heterogeneity in impact of crisis across states. How do maximum rates respond to competition for capital? (Panel C)

21 Benmelech and Moskowitz 21 Table 4: Is Regulation Tighter When it is Less Costly? Panel A: How do Maximum rates respond to market rates? Dependent variable = Maximum legal rate Sample period (Max. rate US bond rate) t (-4.90) (Max. rate PC rate) t (-4.90) (Max. rate Regional rate) t (-5.12)...Regional rate< Max. rate (2.93)...Regional rate> Max. rate (-5.11) (Max. rate State bank rate) t (-2.49)...State bank rate< Max. rate (1.88)...State bank rate> Max. rate (-1.82) Fixed effects: Year? no no yes yes yes yes State? yes yes yes yes yes yes R R 2 after F.E Cluster year year year year year year

22 Benmelech and Moskowitz 22 Panel B: How do Maximum rates respond to Financial Crises? Dependent variable = Max. rate Max. rate Max. rate Max. rate Max. rate Max. rate Sample period Crisis (3.49) (3.09) (2.30) (Max. rate Regional rate) t (-4.97) (-4.11) Crisis (Max. rate Regional rate) t (-2.60) Crisis railroad failure (2.17) Crisis manufacturing capital (1.66) Crisis machinery capital (2.27) Fixed effects: Year? no no no yes yes yes State? yes yes yes yes yes yes R R 2 after F.E Cluster year year year year year year Panel C: How do Maximum rates and lending volume respond to Competition? Dependent variable = Max. rate t Max. rate t Loans per capita Sample period Max. rate of border states t (6.03) (2.79) Max. rate of non-border states t (0.11) (0.41) Border own wealth (-3.05) Border border wealth (2.15) border rate> 0, own rate< (-2.78) border rate< 0, own rate (2.41) Fixed effects: Year? yes yes yes State? yes yes yes R R 2 after F.E

23 Benmelech and Moskowitz 23 Determinants of Usury Laws Private interests and incumbent political power. (Table 5) Measure of political power: Restricted suffrage laws. Restriced suffrage = 1 if state only allows land owners and/or those who paid significant taxes to vote in that year. Supported by economic history literature. (Engerman and Sokoloff (1997), Engerman, Haber, and Sokoloff (2000), Sokoloff and Engerman (2000)) Another proxy: % of Non-voting White males. Available in 23 states from election years 1824, 1828, 1832, 1836, 1840, and 1844.

24 Benmelech and Moskowitz 24 Figure 3. Time-Series of Maximum Allowable Interest Rate and Usury Penalty for Wealth-Based Restricted and Non-Restricted Suffrage States (1750 to 1891) 0.13 Restricted suffrage states Non restricted suffrage states 0.12 *1873 Crisis 0.11 *1884 Crisis 0.1 Maximum Rate 0.09 *Civil War end 0.08 *1857 Crisis *1819 Crisis Year 5 Restricted suffrage states Non restricted suffrage states Penalty Index *1819 Crisis * 1857 Crisis *Civil War end* 1873 Crisis *1884 Crisis Year

25 Benmelech and Moskowitz 25 Table 5: Private Interests and Incumbent Political Power Panel A: Restricted suffrage and Usury laws %Non-voting Dependent variable = Max. rate white males Max. rate Max. rate Max. rate Max. rate Sample period Restricted suffrage (-2.71) (3.17) (-12.02) (-7.15) (-7.42) %Non-voting while males (-3.01) (-1.60) (5.34) Restricted suffrage %NVWM (-6.67) Restricted suffrage Crisis t (1.56) Restricted suffrage Crisis t (-2.51) Fixed effects: Year? yes yes yes yes yes yes State? yes yes yes yes yes yes R R 2 after F.E Cluster state state state state state state Panel B: restricted suffrage, incorporation laws, and financial crises Dependent variable = Restricted incorporation Restricted incorporation Restricted suffrage Sample period levels changes levels changes levels changes Restricted suffrage (3.71) (3.09) Crisis (-0.90) (-1.09) (-0.02) (0.85) Fixed effects: Year? no no no no yes yes State? yes no yes no yes no R R 2 after F.E Cluster state state state state state state

26 Benmelech and Moskowitz 26 Determinants of Usury Laws Interaction of incumbent political power with financial crises. Relationship between incumbent political power and other forms of economic regulation. Usury laws coexist with other policies designed to exclude certain groups. When voting power is restricted, we see financial and economic restrictions. What equilibrium gives rise to restricted suffrage, restricted incorporation, and restricted lending laws? * Incumbent interests is the omitted variable driving policy.

27 Benmelech and Moskowitz 27 Whose Incumbent Interests are Best Being Served? According to Rajan and Zingales (2003) both industrial incumbents and incumbent financiers may restrict competition through financial development. Can we separate empirically industrialist from financier preferences? (Table 6) Examine free banking laws. Examine combination of policies most favored by financiers versus industrialists and their relation to usury laws.

28 Benmelech and Moskowitz 28 Table 6: Industrial vs. Bank Incumbent Political Power Dependent variable Max. rate Max. rate Max. rate Max. rate Max. rate Sample period Incumbent power Restricted suffrage and incorporation (-2.96) (-2.41) Egalitarian law No restrictions (2.04) (2.80) Free banking laws (-0.48) Industrial incumbent power Restricted suffrage and incorporation, free banking (-2.92) (-3.18) Bank incumbent power Restricted suffrage and banking, free incorporation (0.90) (1.31) Egalitarian law No restrictions (1.49) (1.62) Fixed effects: Year? yes no yes yes no State? no yes yes no yes R R 2 after F.E Cluster state state state state state

29 Benmelech and Moskowitz 29 Testing the Public Interest View of Regulation (Table 7) Protection of the poor: Bankruptcy stay and debt moratoria laws. Awareness of public interests: Newspaper circulation, political coverage, corruption coverage. Idiosyncratic agricultural shocks: Technology (e.g., cotton gin on cotton-producing states) Weather (e.g., 1849 Mississippi River flood on bordering states) Demand (e.g., Crimean War on wheat-producing states) Commodity price shocks (England and Holland commodity price movements times state weight in each commodity)

30 Benmelech and Moskowitz 30 Table 7: Proxies for Public Interests Dependent variable = Maximum legal rate ( ) Bankruptcy stay (-0.97) Debt moratoria vote (-0.08) Newspapers per capita (6.82) Political coverage (0.17) Corruption coverage (-0.64) Agriculture technology shocks (-0.45) Agriculture weather shocks (-0.89) Agriculture demand shocks (-0.34) Commodity price shocks (0.27) Fixed effects: Year? yes yes no no no yes yes yes yes State? no no yes yes yes yes yes yes yes R R 2 after F.E Cluster state state state state state state state state state

31 Benmelech and Moskowitz 31 Alternative Theories of Regulation (Table 8) Bank market power or depth of banking market. Bureaucratic capital. Borrower sophistication. Religious motives. Europe versus U.S.

32 Benmelech and Moskowitz 32 Table 8: Alternative Explanations Using Cross-Sectional Evidence from 1850 Depdendent variable = Maximum legal interest rate Bank concentration (-1.34) Banking wealth (-1.25) %City officers, lawyers (-1.34) %Pupils, publishers (-6.75) Religious accomodations per capita (-5.77) (-6.95) %Roman Catholic accomodations (5.86) R

33 Benmelech and Moskowitz 33 Robustness of Results Same tests applied to penalties for usury (instead of rate ceilings) yield consistent results (with opposite sign). Different treatment of no limit states. Subsample results. Original 13 colonies versus other states.

34 Benmelech and Moskowitz 34 Conclusions We study the political economy of one of the oldest forms of financial regulation. Tension between private and public interests explains the variation in usury laws in the 19th century. Find positive relationship between financial regulation and economic and political restrictions. Political private interests highlight the endogeneous relation between financial and economic development. Can we apply these lessons to today s emerging markets?

35 Benmelech and Moskowitz 35 Table 9: The Relation Between Usury Laws and Economic Growth (1) (2) (3) (4) (5) (6) Per capita State Gross Manufacturing Difference Manufacturing Manufacturing Difference growth rates in: Product Value Added (2) (1) Establishments Employment (2) (4) Panel A: Dependent variable = Economic Growth rate from 1850 to 1860 Max. rate 1840: (4.26) (2.60) (-4.44) (-4.77) (-4.75) (4.25) Fixed effects: region region region region region region R Panel B: Dependent variable = Economic Growth rate from 1860 to 1870 Max. rate 1850: (2.49) (1.47) (-2.59) (-2.68) (-2.66) (2.41) Fixed effects: region region region region region region R