Financial Regulation and Development

1. Ethiopia (2010–2013). In April 2011, the NBE announced the establishment of a new bond market (NBE Bill), forcing banks to purchase 0.27 birr of this bond for every birr of private lending. This can be mapped in a neat increase _s_ .

2. Antebellum USA (1800–1861). Following the establishment of the federal government, American states lost significant revenue from seigniorage and counterbalanced this by imposing significant taxes on banks’ capital or profits (Sylla, Legler, and Wallis, 1987). In section 3 we propose a slightly different theoretical framework, highlighting how these state-specific taxes mapped into an increase in _s_ .

In both of these cases there occur the imposition of safe assets for banks: in Ethiopia this occurs directly, by mandating their purchase; in Antebellum USA, a change in the relative price of safe-torisky assets lead to an observationally equivalent result, as highlighted in Section 3. In both contexts, our theoretical model predicts a strong positive effect of financial regulation on deposits and financial development, because both occur in underdeveloped and risky financial systems. Thus, as Figure 2 shows, these represent the experiment ideal in which the gains from regulation can be sizable (a low _p_ parameter).

These sources of variation in _s_ are useful in identifying the effect of financial regulation on bank behavior, and validate the results of Propositions 1 and 2. Their identification emerges from the following.

- Bank size heterogeneity in Ethiopia. The Ethiopian private banking sector seems to be traditionally divided between six very large banks and eight much smaller banks. This cross-sectional heterogeneity captured through _η_ is combined with the time-series shock to _s_<sup>_R_</sup> to test our model.

- Time heterogeneity in bank tax adoption and bank size across US states. This policy is not simultaneously adopted by all states, with some states being early movers (Massachusetts and Maine in 1812) and others at late stage (New York and Connecticut in 1839 and 1850). We combine the size of the bank with the policy introduction at state level.

In both cases, we exploit time-series variation, exploiting monthly data for the case of Ethiopia and yearly data for the USA, combining this with the use of a difference-in-difference analysis. The results do not seem to reject the mechanism we proposed in the previous section.

# **2.1 Evidence from Ethiopia**

In this section, we present some empirical evidence on Ethiopia<sup>7</sup> and the behavior of its local private banks, exploiting the introduction of a new financial regulation measure introduced in April 2011.

> 7Ethiopia is the second-most populous country in sub-Saharan Africa with a population exceeding 90 million. It is also among the world’s poorest countries: per capita income lies at $500 (World Bank 2013), substantially lower than the regional average, yet growing steadily at more than 10% per year in the last decade. The government’s role in the economy is very active, and the financial sector is not an exception. The Ethiopian banking system presents a large state-owned bank, the CBE, which accounts for 50% of the market, and 14 private commercial banks, which account for the remaining part (in 2011). This contrasts with the trend observed in sub-Saharan Africa and across

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