The Development Impact of Financial Regulation: Evidence from Ethiopia and Antebellum USA

Does financial regulation promote financial development by restraining banks profitability? We test this hypothesis in a model with a monopolistic bank investing in branches over a geography and facing classical maturity mismatch. Financial regulation lowers profits by pushing the bank to hold more precautionary holdings and lend less. Because the default probability declines, the bank partly compensates the profit loss and take on more risk by opening new branches. The regulation cause an unambiguous decline in profits, increase in deposits, while two forces affect lending: loans become smaller in old branches (intensive margin); the number of loans increases because of new branches (extensive margin). We show conditions under which the second effect dominates and the regulation makes the bank bigger, safer and less profitable. Two empirical tests are presented: 1) a regulation change by the National Bank of Ethiopia in 2011; 2) the state roll-over of bank taxes in Antebellum USA (1800-1861). Analyzing bank balance sheets, we find that these policies lower profits and increase branches, deposits, loans and overall precautionary holdings.