Credit Competition Affect Small-Firm Finance PDF

THE JOURNAL OF FINANCE
VOL. LXV, NO. 3
JUNE 2010
Does Credit Competition Affect
Small-Firm Finance?
TARA RICE and PHILIP E. STRAHAN
ABSTRACT
While relaxation of geographical restrictions on bank expansion permitted banking
organizations to expand across state lines, it allowed states to erect barriers to branch
expansion. These differences in states branching restrictions affect credit supply.
In states more open to branching, small rms borrow at interest rates 80 to 100
basis points lower than rms operating in less open states. Firms in open states also
are more likely to borrow from banks. Despite this evidence that interstate branch
openness expands credit supply, we nd no effect of variation in state restrictions on
branching on the amount that small rms borrow.
RELAXATION OF GEOGRAPHICAL restrictions on bank expansion was completed
in 1997, when the Interstate Banking and Branching Efciency Act (IBBEA)
permitted banks and bank holding companies to expand across state lines.
This legislation seemingly ended the era of geographical restrictions on bank
expansion that date back to the 19th century (Kroszner and Strahan (2007)).
In 1994, while most states allowed out-of-state bank holding companies to own
in-state banks (interstate banking), there were almost no interstate branches.
IBBEA, which was passed in 1994, allowed both unrestricted interstate bank-
ing (effective in 1995) and interstate branching (in effect in 1997). Allowing
interstate branching was the watershed event of IBBEA.
However, the interstate branching provisions contained in IBBEA granted
states the right to erect roadblocks to branch expansion, and some states took
advantage of these provisions by forbidding out-of-state banks from opening
newbranches or acquiring existing ones, by mandating age restrictions on bank
branches that could be purchased, or by limiting the amount of total deposits
any one bank could hold. State exercise of such powers restricted entry by large,
national banks and distorted their means of entry. This recent history continued
Rice is from the Board of Governors, Division of International Finance, and Strahan is from
Boston College, Wharton Financial Institutions Center and NBER. The views expressed in this
paper are solely those of the authors and should not be interpreted as reecting the views of
the Board of Governors or the staff of the Federal Reserve System. We thank Ron Borzekowski,
Courtney Carter, Diana Hancock, Traci Mach, Richard Porter and John Wolken for providing
data and research support, and acknowledge the helpful comments of Robert DeYoung, Campbell
Harvey, Mitchell Petersen, the associate editor, an anonymous referee, and seminar participants
at the Federal Reserve Bank of Chicago, the Federal Reserve Board, the 2008 Federal Reserve
Bank of Chicago Conference on Bank Structure and Competition, and the 2009 American Finance
Association Meetings.
861
862 The Journal of Finance
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a long political struggle that had been playing out between large, expansion-
minded banks (who have favored removing barriers to expansion) and small,
insulated banks (the typical beneciaries of these regulatory constraints).
In this paper, we use differences in regulatory barriers to interstate branch-
ing as an instrument to test how credit competition affects credit supply and,
in turn, small-rm nancial decisions. Our approach shares some similari-
ties with the bank lending literature from macroeconomics, which began with
Bernanke (1983). These studies exploit variation in the amount of credit avail-
able due to changes in monetary policy (e.g., Bernanke and Blinder (1988),
Kashyap and Stein (2000)), variation from exogenous shocks to bank capi-
tal (Peek and Rosengren (2000), Ashcraft (2005), Chava and Purananadam
(2008)), or variation in bank liquidity (Khwaja and Mian (2008), Paravisini
(2008), Loutskina and Strahan (2009)). Most authors nd that declines in loan
supply translate into less debt for nonnancial rms, and early evidence sug-
gests that the Financial Crisis of 2007 to 2008 led to very sharp declines in new
loan originations (Ivashina and Scharfstein (2009), Strahan (2009)). Our strat-
egy differs from this literature, however, because the instrument varies credit
competition. We rst tie changes in competition to credit supply conditions, and
then tie these changes to rm capital structure choices.
In our rst tests, we show that in states where restrictions on out-of-state
entry are tight, rms pay higher rates for loans than similar rms operating
where restrictions are loose. The difference in rates translates into a savings of
80 to 100 basis points, comparing rms in states most open to branching with
those instates least open. We also nd that small rms are more likely to borrow
from banks where branching is less restricted. Together these results indicate
that more vigorous competition between banks expands the supply of capital
frombanks. Our ndings are robust to inclusion of credit demand controls such
as time-varying industry effects, local economic growth, the relative importance
of small rms in the state, the importance of small banks in the state, as well
as state xed effects. We nd some evidence that both interest group and
economic growth help explain states choices about branching restrictions, but
these factors do not subsume our key result: credit competition leads to lower
loan rates.
We next test whether branching reform affects capital structure. Do the de-
clines in borrowing rates frombetter competition translate into more borrowing
and less binding credit constraints? To our surprise, we nd no signicant in-
crease in any measure of the quantity of credit. More rms use bank debt
in states open to interstate branching (consistent with greater competition
across banks), but this does not translate into more total borrowing, higher
rates of credit approval, or changes in debt maturity. We nd some evidence
of an increase in the use of expensive trade credit where interstate branch-
ing is unfettered, suggesting that competition may actually increase credit
rationing even as prices fall. These nonresults help validate the identica-
tionassumption that our instrument is not correlated withcredit demand (since
quantity should rise with demand). Moreover, the result lines up with earlier in-
stances of intrastate (as opposed to interstate) branching reform. Jayaratne and
Does Credit Competition Affect Small-Firm Finance? 863
Strahan (1996) nd that economic growth accelerated after reform because the
banking system became more efcient and competitive, allowing greater en-
try of small business (e.g., Black and Strahan (2002), Cetorelli and Strahan
(2006), Kerr and Nanda (2009)). Their evidence points to better quality lending
and lower loan prices (e.g., lower loan losses and lower rates of bank loans)
after reform as the key to better growth performance, rather than an increase
in credit demand. Similarly, Bertrand, Schoar, and Thesmar (2007) nd that
banks in France improve loan quality by reducing credit to poorly performing
rms when government subsidies were reduced following reform in 1985.
Our study extends earlier research on intrastate branching reform because
the more recent deregulation allows us to use the Survey of Small Business
Finance (SSBF), which includes data on borrowing costs, nonprice loan terms,
and measures of capital structure. By studying nancial policy, we extend
the new literature linking credit supply to capital structure. Several of these
papers link leverage to credit ratings. For example, Faulkender and Petersen
(2006) nd that rms with a credit rating have higher leverage than those
without; Kisgen (2009) nds that rms adjust leverage to maintain a good
credit rating; and Su (2009) nds that rms receiving newly introduced bank
loan ratings increase leverage. While these studies suggest that credit supply
affects leverage, they all face the challenge of separately identifying credit
supply from credit demand. Zarutskie (2006) tests how interstate branching
reform affected capital structure, nding some evidence of declines in the use
of debt for very young rms and increases for more seasoned rms. However,
her data do not allow her to test how small-rm loan pricing, nonprice terms
(collateral, guarantees, and maturity), and loan denial rates change following
reform, and thus she is unable to trace out how the regulatory reform affected
competitive conditions within the banking industry and how those changes
affected credit constraints for borrowers.
Lemmon and Roberts (2009) and Leary (2009) use natural experiments to
trace out credit supply shocks, similar to our empirical strategy. Lemmon and
Roberts nd that debt issuance and investment fell for speculative-grade rms
in the wake of the Drexel failure, suggesting that a negative supply shock
reduced access to capital. However, they nd no change in leverage ratios
junk bond rm issuance of both debt and equity declined with the demise
of Drexel, leaving leverage ratios unchanged. Leary exploits two shocks to
the banking system during the 1960sthe introduction of CDs in the early
1960s (a positive supply shock) and the 1966 Credit Crunch (a negative supply
shock). He nds that rms substituted into (away from) bank debt following
the positive (negative) supply shock, leading to increased leverage.
1
Our study differs from the existing literature in two important ways. First,
we study small rms (the largest rm has 500 employees) rather than large
1
Additionally, Kliger and Sarig (2000) and Tang (2009) exploit the increase in information
content from Moodys 1982 ratings renement (adding 1, 2, or 3 to the letter-grade ratings
bins). Kliger and Sarig nd that yields fell for rms near the top of the ratings bins, while Tang
(2006) shows that this change reduced the cost of capital and led to more borrowing, higher
leverage, and greater investment.
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ones (e.g., Compustat rms). Introducing adverse selection or moral hazard
problems, which likely matter most for small and private rms, may complicate
how credit supply affects capital structure. If lenders restrict quantity under
asymmetric information (e.g., Stiglitz and Weiss (1981), Holmstrom and Tirole
(1997)), then a lower cost of debt (from supply shocks) may not translate to
higher leverage. Second, our instrument varies credit supply by changing the
degree of competition across lenders. Much of the existing literature focuses
on changes in banks access to funds. For example, Khwaja and Mian (2008)
exploit bank runs following Pakistans unexpected nuclear test in 1998; they
show that rms borrowed less from banks experiencing greater runs and more
from banks experiencing smaller runs. Paravisini (2008) nds that protable
lending expands following an infusion of liquidity by the Argentine government
into banks. Both studies nd big changes in the amount of credit, especially for
small rms, while we nd no change in quantity but a large change in price.
Our study extends the existing literature by demonstrating that branching
indeed expands competition and credit supply (loan prices fall), and by showing
that the expanded supply does not translate into more borrowing (loan terms
do not loosen). Increased competition may actually worsen nancial contract-
ing problems at the same time that it forces prices down. Entry can worsen
adverse selection (Marquez (2002)), while declines in market power may harm
relationship formation (Petersen and Rajan (1995)). So, lower loan prices re-
duce borrowing costs but banks continue to limit credit to solve contracting
problems, which may even worsen somewhat with greater competition.
2
As
noted above, we nd some (limited) evidence that credit rationing increases in
states most open to interstate branching. In conjunction with the earlier liter-
ature, the results imply that the effects of credit supply on capital structure
depend on what caused the expansion in supply.
The remainder of the paper is structured as follows. In Section I, we discuss
the relaxation of restrictions on bank expansion through interstate banking
and branching, both prior to and following IBBEA. In Section II, we present
our data, empirical design, and results. Finally, in Section III we conclude.
I. Relaxation of Restrictions on Bank Expansion
A. Toward Interstate Banking and Branching
Restrictions on banks ability to expand geographically date back to colo-
nial times (see Kroszner and Strahan (2007)). Federal legislation formalizing
state authority to regulate in-state branching became law with the adoption
of the 1927 McFadden Act. Economides, Hubbard, and Palia (1996) examine
the political economy behind the passage of the McFadden Act and nd results
consistent with a triumph of the numerous small and poorly capitalized banks
over the large and well-capitalized banks.
2
Credit constraints in the smallest rms may be reected in areas other than capital structure,
such as in labor productivity (Garmaise (2008)) or leasing versus purchasing decisions (Eisfeldt
and Rampini (2009)).
Although there was some deregulation of branching restrictions in the 1930s,
about two-thirds of the states continued to enforce restrictions on in-state
branching well into the 1970s. Only 12 states allowed unrestricted statewide
branching in 1970, and another 16 states prohibited branching entirely. Be-
tween 1970 and 1994, however, 38 states eased their restrictions on branching.
Kroszner and Strahan (1999) show that the timing of this state-level deregu-
lation reected the political clout of interest groups within nancial services,
particularly large-bank and small-bank interests. States dominated by well-
capitalized large banks tended to reform branching restrictions early.
The reform of restrictions on intrastate branching typically occurred in a
two-step process. First, states permitted multibank holding companies (MB-
HCs) to convert subsidiary banks (existing or acquired) into branches. MBHCs
could then expand geographically by acquiring banks and converting them into
branches. Second, states began permitting de novo branching, whereby banks
could open new branches anywhere within state borders.
In addition to branching limitations, states also prohibited cross-state own-
ership of banks and bank branches. Following passage of the McFadden
Act, banks had begun to undermine state branching restrictions by building
MBHCs with operations in many states. The Douglas Amendment to the 1956
Bank Holding Company (BHC) Act ended this practice by prohibiting a BHC
from acquiring banks outside the state where it was headquartered unless the
target banks state permitted such acquisitions. Since all states chose to bar
such transactions, the amendment effectively prevented interstate banking.
The rst step toward interstate banking came in 1978, when Maine passed a
law allowing entry by out-of-state BHCs if, in return, banks from Maine were
allowed to enter those states.
3
No state reciprocated, however, so the interstate
deregulation process remained stalled until 1982, when Alaska and New York
passed laws similar to Maines. Other states then followed suit, and state
deregulation of interstate banking was nearly complete by 1992, by which time
all states but Hawaii had passed similar laws. These state changes, however,
did not permit banks to open branches across state lines.
4
The transition to full
interstate banking was completed with passage of the Interstate Banking and
Branching Efciency Act of 1994 (IBBEA), which effectively permitted bank
holding companies to enter other states without permission and to operate
branches across state lines.
B. Interstate Branching after IBBEA
Despite the passage of IBBEA, the struggle over bank expansion continued
as some states exercised their authority under the new law to restrict or limit
3
Entry in this case means the ability to purchase existing whole banks; entry via branching was
still not permitted.
4
Eight states (Alaska, Massachusetts, NewYork, Oregon, Rhode Island, Nevada, North Carolina
and Utah) allowed limited interstate branching. However, interstate branching was not exercised
in these states except in a few cases prior to the passage of IBBEA in 1994.
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interstate branching. While IBBEA opened the door to nationwide branching,
it allowed the states to have considerable inuence over the manner in which it
was implemented. States that opposed entry by out-of-state banks could use the
provisions contained in IBBEA to erect barriers to some forms of out-of-state
entry, to raise the cost of entry, and to distort the means of entry. From the time
of enactment in 1994 until the branching trigger date of June 1, 1997, IBBEA
allowed states to employ various means to erect these barriers. States could set
regulations on interstate branching with regard to four important provisions:
(1) the minimum age of the target institution, (2) de novo interstate branching,
(3) the acquisition of individual branches, and (4) a statewide deposit cap.
Although IBBEA expressly permits interstate branching through interstate
bank mergers, IBBEA preserves state age laws with respect to such acquisi-
tions. Under IBBEA, states are allowed to set their own minimum age require-
ments with respect to how long a bank must have been in existence prior to its
acquisition in an interstate bank merger, although the state law cannot impose
an age requirement of more than 5 years. If a newly established subsidiary
ofce is located in a state that mandates a minimum age requirement, then the
BHC has to wait to convert the subsidiary to a branch until the subsidiary has
met the necessary age requirement. Many states set their age requirement at
5 years, but several states implemented a lower age requirement (3 years or
less) or required no minimum age limit at all.
While interstate branching done through an interstate bank merger (e.g., the
purchase and conversion of an existing bank to a branch ofce) is nowpermitted
in every state, de novo interstate branching is only permitted under IBBEA
if a state expressly opts-in. A bank thus may only open a new interstate
branch if state law expressly permits it to do so. A de novo branching rule
subjects existing banks to more new competition by out-of-state institutions by
making it easier for an entering bank to locate its branches in markets with
the greatest demand for nancial services. Without de novo branching, entry
into a particular out-of-state market becomes more difcult, because it is only
possible via an interstate whole-bank merger, and it also potentially distorts
or limits the entering banks choice of where to locate within the state.
IBBEA species a statewide deposit concentration limitation of 30% with
respect to interstate mergers that constitute an initial entry of a bank into
a state. IBBEA protects the right of each state to cap, by statute, regulation,
or order, the percentage of deposits in insured depository institutions in the
state that is held or controlled by any single bank or BHC. A state is free to
relax the concentration limitation to above 30% or to impose a deposit cap on
an interstate bank merger transaction below 30% and with respect to initial
entry. The obvious impact of such a statute would be to prevent a bank from
entering into a larger interstate merger in the state. For example, if a state
had set a deposit cap of 15%, a bank could not enter into an interstate merger
transaction with any institution that held more than 15% of the deposits in
that particular state.
IBBEA dictates that an interstate merger transaction may involve the ac-
quisition of a branch (or number of branches) of a bank without the acquisition
of the entire bank, only if the state in which the branch is located permits such
a purchase. Like de novo branching, states must explicitly opt-in to this pro-
vision. Permitting acquisition of individual branches lowers the cost of entry
for interstate banks. Rather than being required to enter the market by buying
an entire bank, a bank may instead pick and choose those interstate branches
that it wants to acquire.
We use these four state powers to build a simple index of interstate branching
restrictions. The index is set to zero for states that are most open to out-
of-state entry. We add one to the index when a state adds any of the four
barriers just described. Specically, we add one to the index: if a state imposes
a minimumage of 3 years or more on target institutions of interstate acquirers;
if a state does not permit de novo interstate branching; if a state does not permit
the acquisition of individual branches by an out-of-state bank; and if a state
imposes a deposit cap less than 30%. The index therefore ranges from zero to
four. Table I describes in detail how each state chose to deal with the possibility
of interstate branching following IBBEA. States such as Illinois (since 2004),
Massachusetts, and Ohio have the most open stance toward interstate entry;
states such as Arkansas, Colorado, and Montana have the most restrictive
stance toward interstate entry. Figure 1 depicts the deregulatory history with
a simple timeline. Intrastate branching began in the 1970s and was completed
by the early 1990s; cross-state expansion through MBHCs began in the early
1980s, and grewsteadily through the middle of the 1990s. Interstate branching
(our focus here) began in earnest following passage of IBBEA in 1997 and
expanded into the early 2000s.
C. Latter-Day Branching Restrictions Continue to Bind
Interstate branching has made dramatic inroads in many states. By 2004,
almost half of all branches in the United States were owned by banks with
branch operations in more than one state. Yet, the actual degree of entry by
interstate banks has been constrained in many states by state authority to
erect barriers to entry. We have already described the tools that IBBEA gives
states to reduce or distort the means by which banks may enter. Johnson and
Rice (2008) build a data set of the share of interstate branches as a percentage
of total branches in each state-year from 1994 to 2005. They show that, indeed,
states with greater restrictions in fact have fewer interstate branches as a
share of total branches.
II. Data, Empirical Design, and Results
A. Data
We combine data fromthe Survey of Small Business Finance (SSBF) with the
state-level branching restrictions index dened above. The SSBF is a survey
by the Federal Reserve of the nancial condition of rms with fewer than
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Table I
State Interstate Branching Laws: 19942005
This tables lists the index of interstate branching restrictions, the effective date of interstate
branching regulation changes, and each of the following four provisions: the minimum age of
the institution for acquisition, allowance of de novo interstate branching, allowance of interstate
branching by acquisition of a single branch or portions of an institution, and statewide deposit cap
on branch acquisitions. The index is set to zero for states that are most open to out-of-state entry.
We add one to the index when a state adds any of the four barriers just described. Specically, we
add one to the index: if a state imposes a minimum age of 3 or more years on target institutions
of interstate acquirers; if a state does not permit de novo interstate branching; if a state does not
permit the acquisition of individual branches by an out-of-state bank; and if a state imposes a
deposit cap less than 30%. The index ranges from zero to four. Source: Johnson and Rice (2008).
Minimum Age Interstate Branching Statewide
of Institution Allows by Acquisition of Deposit
Branching (Bank or de novo Single Branch Cap on
Restrictivness Effective Branch) for Interstate or Portions of Branch
State Index Date Acquisitions Branching an Institution Acquisitions
Alabama 3 5/31/1997 5 years No No 30%
Alaska 2 1/1/1994 3 years No Yes 50%
Arizona 2 8/31/2001 5 years No Yes 30%
Arizona 3 9/1/1996 5 years No No 30%
Arkansas 4 6/1/1997 5 years No No 25%
California 3 9/28/1995 5 years No No 30%
Colorado 4 6/1/1997 5 years No No 25%
Connecticut 1 6/27/1995 5 years Yes Yes 30%
Delaware 3 9/29/1995 5 years No No 30%
DC 0 6/13/1996 No Yes Yes 30%
Florida 3 6/1/1997 3 years No No 30%
Georgia 3 5/10/2002 3 years No No 30%
Georgia 3 6/1/1997 5 years No No 30%
Hawaii 0 1/1/2001 No Yes Yes 30%
Hawaii 3 6/1/1997 5 years No No 30%
Idaho 3 9/29/1995 5 years No No None
Illinois 0 8/20/2004 No Yes Yes 30%
Illinois 3 6/1/1997 5 years No No 30%
Indiana 1 7/1/1998 5 years Yes Yes 30%
Indiana 0 6/1/1997 No Yes Yes 30%
Iowa 4 4/4/1996 5 years No No 15%
Kansas 4 9/29/1995 5 years No No 15%
Kentucky 3 3/22/2004 No No No 15%
Kentucky 3 3/17/2000 No No No 15%
Kentucky 4 6/1/1997 5 years No No 15%
Louisiana 3 6/1/1997 5 years No No 30%
Maine 0 1/1/1997 No Yes Yes 30%
Maryland 0 9/29/1995 No Yes Yes 30%
Massachusetts 1 8/2/1996 3 years Yes Yes 30%
Michigan 0 11/29/1995 No Yes Yes None
Minnesota 3 6/1/1997 5 years No No 30%
Mississippi 4 6/1/1997 5 years No No 25%
Missouri 4 9/29/1995 5 years No No 13%
Montana 4 10/1/2001 5 years No No 22%
(continued)
Table IContinued
Minimum Age Interstate Branching Statewide
of Institution Allows by Acquisition of Deposit
Branching (Bank or de novo Single Branch Cap on
Restrictivness Effective Branch) for Interstate or Portions of Branch
State Index Date Acquisitions Branching an Institution Acquisitions
Montana 4 9/29/1995 N/A N/A N/A Increases
1% per year
from 18%
to 22%
Nebraska 4 5/31/1997 5 years No No 14%
Nevada 3 9/29/1995 5 years Limited Limited 30%
New Hampshire 0 1/1/2002 No Yes Yes 30%
New Hampshire 1 8/1/2000 5 years Yes Yes 30%
New Hampshire 4 6/1/1997 5 years No No 20%
New Jersey 1 4/17/1996 No No Yes 30%
New Mexico 3 6/1/1996 5 years No No 40%
New York 2 6/1/1997 5 years No Yes 30%
North Carolina 0 7/1/1995 No Yes Yes 30%
North Dakota 1 8/1/2003 No Yes Yes 25%
North Dakota 3 5/31/1997 No No No 25%
Ohio 0 5/21/1997 No Yes Yes 30%
Oklahoma 1 5/17/2000 No Yes Yes 20%
Oklahoma 4 5/31/1997 5 years No No 15%
Oregon 3 7/1/1997 3 years No No 30%
Pennsylvania 0 7/6/1995 No Yes Yes 30%
Rhode Island 0 6/20/1995 No Yes Yes 30%
South Carolina 3 7/1/1996 5 years No No 30%
South Dakota 3 3/9/1996 5 years No No 30%
Tennessee 1 3/17/2003 3 years Yes Yes 30%
Tennessee 1 7/1/2001 5 years Yes Yes 30%
Tennessee 2 5/1/1998 5 years No Yes 30%
Tennessee 3 6/1/1997 5 years No No 30%
Texas 2 9/1/1999 No Yes Yes 20%
Texas 4 8/28/1995 N/A N/A N/A 20%
Utah 1 4/30/2001 5 years Yes Yes 30%
Utah 2 6/1/1995 5 years No Yes 30%
Vermont 0 1/1/2001 No Yes Yes 30%
Vermont 2 5/30/1996 5 years No Yes 30%
Virginia 0 9/29/1995 No Yes Yes 30%
Washington 1 5/9/2005 5 years Yes Yes 30%
Washington 3 6/6/1996 5 years No No 30%
West Virginia 1 5/31/1997 No Yes Yes 25%
Wisconsin 3 5/1/1996 5 years No No 30%
Wyoming 3 5/31/1997 3 years No No 30%
500 employees.
5
The survey was rst conducted in 1987 and repeated in 1993,
1998, and 2003. It contains details on small businesses income, expenses,
assets, liabilities, and characteristics of the rm, rm owners, and the small
businesses nancial relationships with nancial service suppliers for a broad
5
For complete documentation of the SSBF, see http://federalreserve.gov/pubs/oss/oss3/SSBFtoc.
htm.
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Figure 1. Timeline of intra- and interstate branching deregulation, 19702003.
set of products and services. The sample is randomly drawn but stratied to
ensure geographical representation across all regions of the United States. The
SSBF also oversamples relatively large rms (conditional on having fewer than
500 workers).
Given the above data, we can measure assets, liabilities, prots, rm age,
and the length of time rms have established relationships with banks and
other lenders. We also know the location of rms, so we can control for local
market conditions, and we can use the state of the rm to merge our branching
restrictions variable to the data set. The SSBF also asks about sources of debt.
We use these survey responses to build an indicator equal to one for rms
borrowing from banks.
6
Note, however, that each survey contains a different
sample of rms, so we cannot follow rms over time. Moreover, there are small
differences in variable denitions, so we are somewhat constrained in the way
we construct variables to make sure we have comparability in the results across
over time.
Berger and Udell (1995) and Petersen and Rajan (1994) were the rst to
use these data from the 1987 survey. These papers both nd that banking
relationships expand credit availability for small rms. Other authors have also
used these data to study whether bank size affects credit allocation decisions
(Cole (1998), Jayaratne and Wolken (1999), Cole, Goldberg, and White (2004),
Berger et al. (2005)).
Our paper is the rst to use these data to test whether credit availability
depends on openness to interstate branching. To test this notion, we focus
on the data from the 1993, 1998, and 2003 surveys. The 1993 survey re-
ects credit conditions just before passage of IBBEA and thus represents a
clean control group for our empirical design. To run a falsication test, we
assign the 2003 branching index to the 1993 data. Since deregulation had
not yet occurred, we should observe no relationship between the hypothetical
branching restrictions and credit conditions in 1993. The 1993 survey repre-
sents a better control sample than 1987 because unobservable economic and
6
The SSBF makes it difcult to construct the share of total assets nanced by bank debt because
the balance sheet date is not the same as the date at which rms report their borrowing by type
of lender. Hence, we use a simple indicator variable to test whether the quantity borrowed from
banks increases as barriers to entry fall.
technological factors are more similar to the post-interstate banking sample
during the latter period compared to the earlier one. The last two surveys
(1998 and 2003) occur after passage of IBBEA; thus, if interstate branching
matters for credit supply, we should observe the state-imposed constraints af-
fecting rms operating in different states in those years. These last 2 years can
be thought of as the treatment group in our empirical design.
We focus on small business data because bank credit supply matters most
for rms without access to national and international equity and debt mar-
kets. Moreover, the survey contains enough detail for us to explore the price
and nonprice terms of loans as well as various measures of rms use of debt
nance.
B. Interest Rate Regression
We begin by testing how loan interest rates vary with interstate branching
restrictions. Our interest rate regressions have the following structure:
Y
i, j,t
=
t
Branching Restrictions
j,t
+Interest rate, lender, rmandmarket controls
i, j,t
+
i, j,t
for t = 1993, 1998, and 2003,
(1)
where i is an index across rms, j is an index across states, and t is an index
across years. We estimate equation (1) separately for each of the three sample
years (therefore allowing each coefcient to vary by year). We report weighted
least squares coefcients, using the survey weights provided in the SSBF data
that account for the disproportionate sampling of larger rms and unit nonre-
sponse. The estimated effects of interstate branching restrictions in these WLS
models are larger than those estimated with OLS (see the Internet Appendix
available at http://www.afajof.org/supplements.asp), although the statistical
signicance (or lack thereof) is consistent across either statistical approach.
The dependent variable is the interest rate on the most recent loan. This
variable is only available for about 40% of the rms in the sample. Our state
branching restriction index is Branching Restrictions, which varies between
zero and four. Note that the branching restriction index does not vary across
rms operating in the same state. Since there may be a common element to
the regression error across all rms operating in the same state, we cluster
by state in constructing our standard errors. We have also estimated robust
standard errors without clustering. These standard errors are very close to
those reported here, which suggests that the error term does not contain an
important state-wide component.
7
7
For example, the robust standard error without clustering is 0.078 in the 1998 regressions,
0.070 in the 2003 regression. The robust standard error with clustering is 0.07 in both 1998 and
2003. We thank Mitchell Petersen for suggesting that we compare the state-clustered standard
errors with un-clustered standard errors.
R
C. Control Variables
Following Petersen and Rajan (1994), we include a large number of control
variables in our reported specications, including interest rate variables ob-
served during the month in which the loan was approved, borrower and lender
characteristics, relationship characteristics, and market characteristics. For
interest rate controls, we include the prime rate, a corporate bond default
spread equal to the difference between the corporate bonds rated BAA and the
yield on the 10-year government bonds, and a term structure spread equal to
the difference between the yield on the same 10-year government bonds minus
the 3-month constant maturity Treasury bill yield.
8
We include an indicator if
the lender is a bank and another indicator if the lender is a nonnancial rm.
For loan terms, we include an indicator for oating rate loans.
As additional controls for market structure (beyond the branching restric-
tions), we include an indicator for urban markets, a measure of concentration
in the local market, and the growth rate of local output during the 5 years prior
to the survey year. The concentration measure equals the Herndahl index
(HHI) from deposits in the local market, which has been used for antitrust
enforcement in bank mergers. Local output is measured by the average lagged
per capita personal income growth rate during the preceding 5 years. Urban
markets are dened as Metropolitan Statistical Areas (MSAs), rural markets
are dened by county, and for consistency across the 3 survey years, we use the
2003 market denitions from the U.S. Census Department.
For borrower control variables, we include rm size (log of assets) and rm
age (in years), the lenders risk assessment of the borrower, an indicator for
corporations, indicators for the two-digit SIC code of the borrower (this adds
upward of 50 variables to the model), return on assets (net income/assets),
the length of the relationship between the borrower and lender (in years),
the number of information- and noninformation-based services that come
from the lender, the number of unique relationships the borrower has with
all of its lenders, and an indicator equal to one if the borrower has a deposit
account with the lender. Information services are dened as those services that
the borrower can purchase from the lender that can be used by the lender to
monitor the rm (such as cash management services or credit card processing).
Noninformation services are those services, also purchased by the borrower,
that arguably do not give the lender additional information with which to mon-
itor the borrower (Petersen and Rajan (1994)). Finally, we include the credit
risk rating of the borrower, which varies from one to ve, with one indicating
the safest type of borrower and ve the riskiest.
9
This credit risk rating is de-
rived from the Dun and Bradstreet credit score of the company and is available
in all survey years.
8
The rate on the most recently approved loan is as of the month of the approval. We match this
rate to the monthly observations on the interest rate controls.
9
In the 2003 survey, the risk rating varies from 1 to 6, with 6 being least risky, while the ratings
for the 1993 and 1998 surveys vary from 1 to 5, with 5 being the most risky. For comparability over
time, we recalibrate the 2003 rating to lie between 1 and 5, with 5 being the most risky.
D. Summary Statistics
Table II reports the summary statistics on the interest rate on the most
recent loan, the branching restrictions index, and all of the control variables.
The average interest rate on loans ranged from8.5%in 1993, to 9.0%in 1998, to
5.8% in 2003. In each year, these rates exceed the prime interest rate because
the sample contains small and risky rms. The variation over time reects
mainly the change in the overall level of interest rates, although the average
spread over the prime rate does fall in 1998 relative to the other two survey
years. Many of the variables are quite stable over time (e.g., borrower risk
rating, market characteristics), although we see a spike in the frequency of xed
rate borrowing and loan maturity during the 1998 sample, probably because
of the relatively at term structure during that year. We do see the incidence
of collateral decline across all three samples, from 72% of loans in 1993 to just
55% by 2003.
Firmsize and rmage both decline sharply between 1993 and 1998, and then
both increase again in 2003. We also see a drop in the importance of banks as
lenders in 1998, which again rebounds in 2003. These patterns likely reect
the large number of start-up rms entering the economy during the boom of
the second half of the 1990s, along with the growth of nontraditional nanciers
such as venture capitalists during those years. This change in the structure of
the economy also shows up in the average relationship length between rms
and lenders, which falls from 8.1 to 5.5 years between 1993 and 1998, and
then increases to more than 10 years by 2003. While the sample size in 1998
is smaller than in the other 2 years, the mean rm characteristics are similar
other than rm size and age.
E. Relaxing Branching Restrictions Lowers Loan Prices
Table III reports our benchmark regression result linking the interest rate
paid on the most recent loan to branching restrictiveness and the other vari-
ables. Columns 1 through 6 report these regressions for 1993, 1998, and 2003.
As noted earlier, 1993 represents the control or placebo group. We assign the
2003 branching index to each observation in the 1993 equation; if our identi-
cation strategy works, there should be no impact of this hypothetical index
in that year, since before 1994 all states prohibited interstate branching. As
shown in the table, the coefcient on branching restrictions is small and not
statistically signicant in 1993. Thus, there is no placebo effect of branching
restrictions. This is important because, if there were systematic differences
in unobservable dimensions that are correlated with a states stance toward
banking, these would bias our results.
In contrast to 1993, branching restrictions enters with a positive and statisti-
cally signicant coefcient in both 1998 and 2003. The coefcients are similar
in magnitude in the 2 years (0.21 and 0.25). The coefcient of 0.25 in 2003
suggests that in states completely open to branching, rms could borrow at
rates about 100 basis points lower than they could in states with the most
R
Table II
Summary Statistics
This table reports summary statistics from the 1993, 1998, and 2003 Surveys of Small Business
Finance. Each survey contains a random sample of rms with fewer than 500 employees. Each
sample is drawn independently, so we do not follow the same rms over time. The data on loan
terms, interest rates, loan characteristics, and lender characteristics reect information from the
most recent loan by the borrower; these data are available for about 40% of the sample. The other
statistics are available for all of the respondents, but here we report the summary statistics for
the smaller sample that is included in the interest rate regressions (Tables III and V). Market
concentration equals the sum of squared share of deposits held by all banks in the borrowers local
market, where market is dened as the Metropolitan Statistical Area (MSA) or county.
1993 1998 2003
Standard Standard Standard
Mean Deviation Mean Deviation Mean Deviation
Loan terms
Interest rate on most recent loan 8.47 2.21 9.04 2.37 5.79 2.68
Share with collateral 0.72 0.45 0.63 0.48 0.55 0.50
Share guaranteed 0.56 0.50 0.56 0.50 0.60 0.49
Loan maturity (years) 3.28 4.38 4.57 5.49 3.76 4.95
Index of branching restrictions
4 is most, 0 least, restricted 1.99 1.35 2.43 1.41 2.05 1.34
Interest rates
Prime interest rate 6.00 0.00 8.35 0.27 4.13 0.12
Term structure (10-year
government bond 3-month
T-bill)
2.84 0.36 0.35 0.14 2.94 0.39
Default premium (BAA
10-year government bond)
4.91 0.42 2.31 0.35 2.75 0.29
Borrower characteristics
Log of borrower assets 13.25 2.11 12.75 2.25 13.51 2.13
Indicator if borrower is a
corporation
0.46 0.50 0.33 0.47 0.33 0.47
Borrower ROA 0.33 0.65 0.66 1.10 0.46 0.82
Borrower risk rating (1 is safest;
5 is riskiest)
2.94 1.16 3.00 1.14 2.74 1.18
Loan characteristics
Indicator if loan is oating-rate 0.58 0.49 0.34 0.47 0.55 0.50
Lender characteristics
Indicator if lender is a bank 0.88 0.33 0.77 0.42 0.87 0.34
Indicator if lender is a
nonnancial company
0.03 0.16 0.05 0.21 0.02 0.14
Indicator if loan is a line of
credit renewal
N/A 0.46 0.50
Relationship variables
Length of lenderborrower
relationship (years)
8.07 8.34 5.48 7.09 10.37 10.56
Borrower age (years) 16.27 14.24 13.90 10.95 18.32 13.08
Number of information services
from lender
0.26 0.44 0.17 0.37 0.39 0.49
(continued)
Table IIContinued
1993 1998 2003
Standard Standard Standard
Mean Deviation Mean Deviation Mean Deviation
Number of noninformation
services from lender
0.26 0.44 0.32 0.47 0.48 0.50
Indicator if borrower has a
deposit with lender
0.72 0.45 0.53 0.50 0.75 0.43
Number of relationships 1.94 1.44 2.10 1.71 2.19 1.57
Market characteristics
Local market concentration 0.16 0.09 0.17 0.09 0.17 0.10
Indicator if borrower is in an
MSA
0.77 0.42 0.74 0.44 0.93 0.26
Lagged 5-year growth rate in
the local market
0.22 0.06 0.25 0.06 0.19 0.06
restrictions on interstate branching (4 0.25 = 1.0 percentage points in the
borrowing rate).
For the control variables, we nd that size is consistently negatively related
to loan interest rates, and borrower risk rating is consistently positively related
to the rates, as one would expect. Many of the other control variables are either
insignicant or not stable across the three samples. This instability is notable
for the relationship variables in particular, where we nd that the relationship
length enters negatively in 1998 but not in the other 2 survey years.
10
Next, we pool our 3 sample years to test whether the effects of branching
restrictions changed signicantly in reaction to passage of IBBEA. In the pooled
model, we include both year and state xed effects, so the coefcient on the
branching restriction index is generated solely by within-state variation over
time. In this case, we code the branching restriction index in 1993 equal to
four, its most restrictive value, for all states. Hence, the variable does not
change over time for states like Colorado, which imposed the tightest level of
restrictions, while it falls from four to zero for states like Illinois, which were
relatively open to interstate expansion. The pooled model allows us to control
for trends by adding year effects, and for persistent differences in states by
incorporating state xed effects, as follows:
Y
i, j,t
=
t
+
j
+ Branching Restrictions
j,t
+Interest rate, lender, rm and market controls
i, j,t
+
i, j,t
, (2)
where
t
are the year-specic xed effects and
j
are the state xed effects. By
including these xed effects, we have stripped out all of the cross-state variation
10
We have tested whether the average length of bank relationships differs as states open up
to interstate branching but nd no evidence that such relationships change. This may occur be-
cause most banks typically buy existing branches when they enter new markets, thus leaving
relationships and relationship length unaffected.
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and thus eliminated the possibility that the coefcient onbranching restrictions
is biased because it is correlated with some unmeasured state characteristic.
This model by necessity constrains the coefcients to be constant over time.
Also, because we only have variation in the branching variable across states
and over time, but not across observations within the same state-year, we
cluster the error at the state-year level in building standard errors.
Columns 7 and 8 of Table III report the pooled, xed effects results of
equation (2). Consistent with the year-by-year regressions, we nd that the
coefcient on branching restrictions is positive and statistically signicant.
The coefcient equals 0.22, which is roughly equal to the average of the ef-
fects from the 1998 and 2003 cross-sections. According to this estimate, states
that relaxed interstate branching restrictions the most enjoyed a decline in
borrowing rates for small rms of about 88 basis points (0.22 4 = 88 basis
points).
F. What Drives the Branching Index?
Deregulation occurs through a political process shaped by interest group
lobbying as well as ideological jockeying between constituents and legislators.
Thus, one concern with our results is that the forces generating variation in
a states stance toward openness to interstate branching may be correlated
with demand for credit in the state, or with other supply-side factors such as
the relative bargaining power of interest groups within the nancial services
sector. For example, if states with strong growth opportunities are more likely
to deregulate, then the branching index may be related to credit demand.
Alternatively, if states with strong allies of large banks are more likely to have
openness to branching, then the results may have to do with the structure of
banks in a state rather than with a change in competition.
We offer three pieces of evidence to rule out these alternative explanations
for our results. First, including state xed effects will strip out any persistent
differences across states. For example, differences in the structure of industry,
or differences in the relative bargaining power of large versus small banks,
will tend to be very persistent and thus will be taken out by the xed effects.
Second, we report the cross-state correlation between variables linked to the
timing of past intrastate (opposed to interstate) deregulation and our branching
index and between lagged and contemporaneous state-level economic growth
and our branching index. Third, we test whether controlling for these factors
in the interest rate model affects the year-by-year results.
In choosing the set of factors possibly related to deregulation, we follow
Kroszner and Strahan (1999), who show that the size of the insurance sector
relative to banking, the size of small banks relative to large, the capital-to-asset
ratio of small banks relative to large, and the fraction of small nonnancial
rms in the state are all related to the timing of intrastate branch reform.
Kroszner and Strahan also nd a limited role for ideologystates controlled by
Democrats were slower to deregulate intrastate restrictions, all else equal. For
the relative size of insurance, we use the ratio of value added from insurance
Table IV
Correlation between Interest Group Factors, Political Factors, and
Economic Conditions with Index of Branching Restrictions
For eachvariable described inthe far left column, this table reports its meanand its correlationwith
the branching restrictions index, where each statistic is built from 51 observations, one per state
(including DC). With the exception of the economic growth variables, all state characteristics are
measured as of 1993, the year before passage of the Interstate Banking and Branching Efciency
Act.

Denotes signicance at the 1% level.
Cross-State Correlation
with Branching Index
Mean 1998 Index 2003 Index
Small bank share of all banking assets in state 0.059 0.49
0.39
Relative size of insurance to banking plus insurance 0.443 0.16 0.22

Small rm share of the number of rms in the state 0.761 0.16 0.15
Capital ratio of small banks relative to large banks 1.39 0.19 0.07
in state (%)
Indicator if governor is Democrat 0.55 0.05 0.01
Share of state legislature that is Democrat 0.65 0.05 0.04
State annual personal income growth: 1993 to 1997 0.053 0.32
0.33
State annual personal income growth: 1998 to 2002 0.051 0.07

to value added from insurance plus banking; these data come from the Bureau
of Economic Analysis. For small bank share, we compute the fraction of total
assets in the state held by banks with assets below the state median, and we
compute the size-weighted average difference in the capital-to-asset ratio of
small banks minus large ones (again using the median asset size to dene
small). Both of these are built from the Call Reports. We use the fraction of
total establishments with fewer than 20 employees in the state, as reported by
the Census Bureau, as a proxy for the share of small nonnancial rms (i.e., the
share of bank-dependent borrowers). To measure political ideology, we compute
an indicator equal to one if the governor is a Democrat, and we also build
the fraction of state legislators who register as Democrats, both taken from the
Book of the States. We compute all of these as of 1993, the year before passage
of IBBEA so that the variables themselves are not affected by restructuring
that may occur as a result of deregulation.
Table IV reports the correlation between our set of interest group, political,
and economic factors with the branching index. We report the correlations in
both 1998 and 2003, using one observation per state. With two exceptions,
these correlations are small and not statistically signicant. There is no cor-
relation between the structure of the nonbanking industry (share of small
rms or the relative importance of insurance), or between the relative power of
Democrats at either the legislative or the executive level. However, consistent
with Kroszner and Strahan (1999), we do nd that states where small banks
are more important choose to restrict out-of-state branching more than other
states (i.e., the correlation is positive). We also nd that states with rapidly
growing economies between 1993 and 1997years before interstate branching
R
went into effecttended to restrict branching more.
11
The correlation with eco-
nomic growth contrasts with the evidence surrounding intrastate branching.
In the early case, there was no correlation between past growth and deregula-
tion, whereas there is a positive association between growth and deregulation
after reform goes into effect (Jayaratne and Strahan (1996)). Thus, states with
weak economies may have viewed increased banking competition as a means
to improve growth prospects going forward. In fact, there is a signicant neg-
ative correlation between the branching restriction index and the change in
growth surrounding reform. Crucially for us, however, there is no contempora-
neous correlation across states between economic conditions and the branching
index, and thus there is little evidence that credit demand is higher in states
that restricted branching than in those that did not during either 1998 or 2003.
Moreover, lagged economic growth does not have a signicant impact on loan
rates in Table III, nor are the effects of the index on interest rates changed if
we drop economic conditions from our model.
To complement our xed effects analysis in ruling out alternative explana-
tions, Table V reestimates the year-by-year regressions after adding each of
the potential state characteristics related to political or ideological factors just
described.
12
We include, in turn, each of the variables identied by Kroszner
and Strahan. To make the table compact, we report only the coefcient on the
branching index and the coefcient on the alternative state characteristic
small bank share (Panel A), the share of insurance relative to insurance plus
banking (Panel B), small rm share (Panel C), the difference between small
and large banks capital to asset ratio (Panel D), an indicator for Democrat
as governor (Panel E), and the share of Democrats in the state legislature
(Panel F).
13
In all but one case, the new control variable is not signicant. The
fraction of small rms does enter the regression with a positive and signi-
cant coefcient in both 1998 and 2003, but not in 1993. However, the effect of
the branching index remains positive and both economically and statistically
signicant when we add this variable to the model.
G. Firms Substitute toward Bank Finance When Branching Is Unrestricted
Declining prices on loans suggest greater competition and credit supply. The
rate regressions, however, include only those rms that actually borrow during
the survey year. The other standard implication of greater supply is an increase
in quantity. We test this by asking whether more rms have bank debt in
states with greater openness toward branching using all of the rms in the
SSBF. The structure is the same as before, except we drop all of the loan
and interest rate variables and include just rm and market characteristics
11
These two effects also correlate signicantly if we estimate a multiple regression.
12
The baseline models in Table IV already control for lagged economic growth, and the results
do not change when we drop this variable.
13
We provide a full set of results in the Internet Appendix (available at http://www.afajof.org/
supplements.asp).
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as explanatory variables. Thus, we include the branching restrictions index
along with the measure of market concentration, the urban dummy variable,
and borrower characteristics (log of assets, age in years, return on assets, risk
rating, an indicator for corporations, and the two-digit SIC indicators). We also
incorporate a measure of bank relationships equal to the length of the rms
longest relationship with a lender. Since the dependent variable is qualitative
equal to one if a rm borrows from a bank and zero otherwisewe estimate a
Probit model. We report the marginal effects rather than the Probit coefcients,
which are difcult to interpret. Columns 1 and 2 of Table VI report the results,
suggesting that rms are more likely to borrow from banks when barriers to
interstate branching are low. The coefcient on the branching restrictions index
of 0.015 is signicant at the 5% level. In the year-by-year models, we nd a
very small and statistically insignicant coefcient in 1993, and although they
are not signicant in the later years, the coefcients are larger and increase
from 0.008 in 1998 to 0.016 in 2003. The pooled model is more powerful
because we can include all of the data to identify the coefcient. Also, the
fact that the coefcients in the cross-sections are similar to the pooled model
with state xed effects provides strong evidence that we have not omitted an
important state-specic variable in our regressions. The magnitude suggests
that a rms probability of borrowing froma bank is about six percentage points
greater in the most open states relative to the least open states.
14
H. Relaxing Branching Does Not Relax Credit Constraints
We have shown that credit supply conditions improve with relaxation of
branching restrictions. Prices fall and more rms borrow from banks when
barriers to entry are low. Does this increase in credit supply relax credit con-
straints for small rms? To address this issue, we look at three measures of
credit access: total debt, measured as log of (1+total debt); a denial indicator
equal to one if a rm was denied credit or was discouraged from applying for
credit; and the percentage of trade credit paid late. The total debt variable is
an all-encompassing measure of how much the rm borrows, and allows us to
include all rms.
15
The denial indicator is also available for the full sample. For
late trade credit, Petersen and Rajan (1994) show that the imputed interest
for rms paying late on trade credit annualizes to 44.6%, thus suggesting that
only credit-constrained rms would use this source of nance. For this variable,
however, we include only rms that have some trade credit. We regress these
three measures (log of total debt, denial of credit, late trade credit) on the same
set of rm and market conditions. And, again, while we estimate these mod-
els for 1993, 1998, and 2003 separately, we report just the pooled model with
14
We have also tested whether the substitution into bank debt is more pronounced for small
and young rms. The sign of these interactions suggests that the effects are larger for the small
and young, but neither effect enters the regression signicantly.
15
We have also modeled the leverage ratio and nd no effects of branching. Leverage is prob-
lematic in our sample of small rms due to a large number of outliers, so we focus here on total
debt.
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state and year xed effects (year-by-year results are available in the Internet
Appendix).
As shown in Table VI (columns 3 through 8), we nd no evidence that branch-
ing restrictionsthe instrument for credit supplyincrease access to credit.
The branching variable is never close to statistically signicant in the models
for total debt or the probability of denial. If we estimate the model on the same
sample as in the interest rate models, we nd no signicant effect of branching
restrictions on total debt or debt denial. We do nd a negative and signicant
coefcient in the trade credit regressions (columns 7 and 8), suggesting, if any-
thing, that credit constraints are tighter in states more open to branching.
While this may reect greater control problems in more competitive markets,
we hesitate to highlight this result because the effect is not statistically robust.
For example, if we do not weight the model, the effect of branching restrictions
on trade credit loses signicance (see the Internet Appendix).
If prices fall, why dont rms borrow more? As we have argued, small rms
have chronic problems raising external nance for both adverse selection and
moral hazard reasons. If credit rationing partially solves contracting problems,
as suggested by classic models such as Stiglitz and Weiss (1981), then there
is no reason to expect these constraints to loosen with more competition. As
further support for this notion, in our last set of tests we ask whether nonprice
loan terms are looser in states more open to branch competition. For this
analysis, we return to the sample of rms with detailed loan information (40%
of the surveyed rms) and report three contracting terms: an indicator for
loans with collateral, an indicator for loans personally guaranteed by the rms
owner (meaning that the lender has some claim against nonbusiness assets in
default), and loan maturity (in years). Our regressors are the same as those
included in the pricing regressions (Table III).
As shown in Table VII, there is no evidence that nonprice terms (collateral,
guarantee, and maturity) loosen with interstate branch openness. In fact, if
we estimate the model without the survey weights, we estimate a negative
and signicant effect of branching restrictions on collateral, meaning that, if
anything, collateral is more common in states with open branching relative to
other states (see the Internet Appendix). Given this result, one might wonder
whether the decline in interest rates occurs because of tighter collateral re-
quirements on loans. This is not the case, as in robustness tests we nd that
adding collateral (as well as adding maturity) has almost no impact on the size
or statistical signicance of branching restrictions in the interest rate models
reported earlier.
The above results suggest that more competition across banks improves loan
pricing and encourages rms to substitute bank debt for other sources of debt.
Firms do benet from the lower prices, but mechanisms that banks and other
lenders use to deal with adverse selection and control problemsrationing
(total borrowing, loan approval rates), collateral, guarantees, and maturity
do not vary. Lenders continue to solve the adverse selection and moral hazard
problems just as much after deregulation as before. By enhancing competition,
branch openness limits banks ability to charge high prices but does not help
them solve contracting problems for small rms.
R
Table VII
Regression of Nonprice Loan Terms from Most Recent Loan on State,
Bank, and Borrower Characteristics (Pooled Models)
This table reports regressions weighted by the survey weights to account for disproportionate
sampling and unit nonresponse, and includes a set of two-digit SIC indicator variables to control
for industry effects. Standard errors are clustered by state-year. A Probit model is estimated for
the collateral and guarantee regressions. The marginal effects, rather than the Probit coefcients,
are reported. Market concentration equals the sum of squared share of deposits held by all banks
in the borrowers local market, where market is dened as the Metropolitan Statistical Area (MSA)
or county. Standard errors are clustered by state-year.
Indicator if Loan
Has Collateral
Indicator if Loan Is
Guaranteed
Loan Maturity
(Years)
Coefcient t-stat Coefcient t-stat Coefcient t-stat
Index of branching
restrictions (4 is most, 0
least, restricted)
0.011 0.87 0.002 0.15 0.198 1.38
Interest rates
Prime interest rate 0.029 0.31 0.095 1.12 0.123 0.17
Term structure (10-year
government bond
3-month T-bill)
0.005 0.13 0.000 0.00 0.464 1.36
Default premium (BAA
10-year government bond)
0.066 1.76 0.035 1.11 0.442 1.47
Borrower characteristics
Log of borrower assets 0.053 6.30 0.022 2.73 0.188 1.72
Indicator if borrower is a
corporation
0.038 1.53 0.089 3.40 1.172 4.96
Borrower ROA 0.010 0.57 0.025 1.93 0.280 1.72
Borrower risk rating (1 is
safest; 5 is riskiest)
0.024 2.62 0.024 2.37 0.104 0.81
Loan characteristics
Indicator if loan is
oating-rate
0.023 1.02 0.117 4.53 0.057 0.22
Lender characteristics
Indicator if lender is a bank 0.052 1.21 0.092 2.03 0.146 0.25
Indicator if lender is a
nonnancial company
0.131 1.32 0.058 0.55 0.773 0.75
Relationship variables
Length of lenderborrower
relationship (years)
0.001 0.40 0.004 3.19 0.023 1.58
Borrower age (years) 0.001 0.89 0.002 1.70 0.005 0.37
Number of information
0.017 0.52 0.015 0.45 0.775 3.39
Number of noninformation
0.014 0.40 0.023 0.98 0.755 3.17
Indicator if borrower has a
deposit with lender
0.110 3.67 0.032 1.00 1.586 4.12
Number of relationships 0.009 1.17 0.039 4.41 0.285 2.90
(continued)
Table VIIContinued
Indicator if Loan
Has Collateral
Indicator if Loan Is
Guaranteed
Loan Maturity
(Years)
Coefcient t-stat Coefcient t-stat Coefcient t-stat
Market characteristics
Market concentration 0.077 0.64 0.062 0.49 0.935 0.75
Indicator if borrower is in an
MSA
0.008 0.27 0.019 0.70 0.359 1.20
Average lagged 5-year growth
rate
0.085 0.45 0.232 1.36 0.465 0.28
N 4,153 4,156 4,065
R
2
11.86% 10.02% 15.91%
III. Conclusions
Barriers to bank expansion, both within and across state lines, have slowly
fallen over the past 30 years. Removing these barriers has led to an increase in
competitive pressure on banks and greater credit supply. Despite these gains,
however, some states continue to exploit their ability to erect barriers to compe-
tition from out of state. We use these differences in state openness to interstate
branching as an instrument for variation in credit competition. In our rst two
main results, we nd that the cost of credit is lower in states open to interstate
branching and that rms shift toward banks. Banks recognize the state-level
anticompetitive burden permitted by IBBEA, and some have pressed the reg-
ulatory agencies and Congress to streamline banking law. A section contained
in the Financial Services Regulatory Relief Act as passed by the House in 2006
would have eliminated remaining interstate branching barriers.
16
According to Federal Reserve Vice Chairman Donald Kohn, the interstate
branching provisions originally contained in the Act would remove the last ob-
stacle to full interstate branching for banks and level the playing eld between
banks and thrifts.
17
Although the nal bill did not contain these provisions,
the issue is sure to be revisited in future bills and legislation.
Despite the gains in credit supply, we nd little variation in access to credit
across states as the degree of branching restrictions loosens; if anything, credit
rationing increases. This nonresult helps validate our key identication as-
sumption that branching reform does not reect variation in credit demand,
since higher demand would naturally be associated with more borrowing. More-
over, our results contrast with several recent studies of larger rms, where debt
16
H.R. 3505 and S. 2856. The House bill, passed in March 2006, contains a section (401) en-
titled Easing the restrictions on interstate branching and mergers, which removes remaining
restrictions on de novo interstate branching and prohibits branching by commercially owned ILCs
chartered after October 1, 2003. The Senate bill, passed in May 2006, contains no such section.
17
Testimony before the Committee of Banking, Housing and Urban Affairs, United States
Senate in March 2006. The testimony is available online at http://www.federalreserve.gov/
boarddocs/testimony/2006/20060301.
R
increases when credit supply expands. Small rms face greater constraints in
their access to external nance than large, public rms, and most external -
nance that small banks can raise comes in the formof debt. Thus, the borrowing
choices of small rms combine standard tradeoffsfor example, taxes versus
nancial distresswith an additional set of constraints on access imposed by
lenders (or external nanciers more generally). Our results suggest that even
when competition improves and the cost of borrowing falls, constraints on
small rms ability to raise external nance, and thus debt nance, continue to
bind.
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VOL. LXV, NO. 3

Relative size of insurance to banking plus insurance 0.443 0.16 0.22

State annual personal income growth: 1998 to 2002 0.051 0.07

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