Financial Regulation and Development default. However, if the government imposes a minimum level of safe asset holding, which has a deterministic return, this moderates both bank profits in the good state and losses in the bad state: it increases depositor repayment and stimulates more deposits. As a consequence, we show that bank profits can rise if deposit growth exceeds the decline in the intermediation margin and loan provision. In such a case, branch installation (financial development) also rises, as higher profitability leads to more branch opening and provision of additional loans. In our model, financial regulation is valuable because of the timing assumption: banks are unable to convince depositors of their safe asset investment because of profit maximization and hence the government needs to create a commitment in holding safe assets.<sup>2</sup> This might be oversimplistic, but could represent, in a reduced form, the inability of depositors to actively monitor the financial system, and regulation could be interpreted as a public good lowering monitoring costs.

While there exists substantial evidence on the beneficial effects of regulation on welfare (e.g., Laffont and Tirole 1993; Glaeser and Shleifer 2001), we are the first to show empirically that financial regulation can promote financial development and that enhanced bank safety is the channel through which this takes place. Such policies have been implemented in several countries over the past century.<sup>3</sup> However, this issue has been difficult to study for a variety of reasons. To begin with, data availability on the banking industry in low-income countries is a severe limit: with the exception of a few, yet incomplete, sources (i.e., the Bankscope database<sup>4</sup> ), most banks are reluctant to publish any documentation that goes beyond the mere legal obligations. However, even when sources are available, they are – unsurprisingly – of low quality, generally incomplete, and only focused on a few key financial variables, with limited details on branching and geographical outreach. In addition to this, the power of the test is generally a sizable problem: most regulation policies are announced quarters/years before the implementation and only gradually brought into operations. This makes it hard to track any behavioral change or, in any case, changes with enough statistical power to study

> 2These results are generally consistent with the work of Gennaioli, Martin, and Rossi (2014), which points to a liquidity benefit of holding public bonds (Holmstrom and Tirole 1998) and hints at the concept of efficient regulation (Shleifer 2010). Recently, Begenau (2015) has presented a model with a similar intuition, showing that capital requirements can generate a lending expansion, by affecting bank debt quantity and price. In a dynamic general equilibrium model, she shows that regulation lowers the supply of bank debt, but the debt price may decline further because of households’ preferences for safe assets, thus lowering the bank funding costs and hence boosting aggregate lending. The endpoint is not dissimilar from ours, with the difference that we focus on an alternative liability (deposits) and consider changes over quantities rather than their prices. Also Eden (2016) highlights the plausible optimality of an intermediation tax, though relating this to a different argument on firms purchases and excessive financing costs.

> 3The regulation of the financial sector, especially concerning the mandatory purchase of safe assets, has a long tradition. A detailed OECD report (Edey and Hviding 1995) documents the historical use of compulsory holdings of government securities across OECD countries, which was especially “important in Italy, Sweden, Norway, Australia, Belgium, Spain, Turkey and Greece”. Also, New Zealand implemented a similar policy in 1973, called the reserve asset ratio, which included a wide range of compulsory requirements to hold specified levels of public sector securities and other financial assets imposed on trading banks, trustee and private savings banks, building societies, private superannuation funds, life insurance companies, and finance companies (Reserve Bank of New Zealand 1985). Also, emerging economies have been adopting similar financial sector policies. For example, Indian banks, life insurance, and pension funds are required to hold a minimum of 25% of their time deposit liabilities in government securities – the Statutory Liquidity Requirement (SLR; Wells and Schou-Zibell 2008). Also, in the mid-1990s Barbados implemented analogous policies, forcing local commercial banks to hold two-thirds of the short-term assets in government securities and over 40% of the market in longer-term securities (Williams 1995).

> 4See http://www.bvdinfo.com/en-gb/our-products/company-information/international-products/bankscope.

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