The causal relationship between finance and economic growth makes “understanding the factors that encourage capital market development […] a key question” (p.138). Meiji-era policy-maker recognized that “the geographical mobility of capital [was] critical to allocative efficiency” and that to modernize the economy they had to forge an integrated capital market (p.139).
Finance in unchartered waters
“Economic theory suggests that asset price ought to obey the law of one price because if capital markets are perfectly competitive and no market frictions exist, arbitrage opportunities should not persist across time and space” (p.140). Indeed the authors” analysis of 47 prefectural markets for loanable funds from 1884 to 1925 presents evidence of a convergence in interest rates (as indicated by the coefficient of variation on a quarterly base; p.141).
“One explanation, for the persistence of high lending rates in some regions is that banks were able to take advantage of market power, and charge local customers higher prices. They effectively exploited their locational advantage to derive monopoly rents. In underdeveloped markets, banks are often able to retain significant market power. Distance from a central financial market can often act as a barrier to entry by making it more costly for a larger, out-of-area bank to establish a branch or purchase an existing bank” (p.142).
Deficient information (e.g. before telegraph) and restrictions on the establishment of new banks and branches may also foster geographic monopolies (p.143).
Unlike the United States, Japan’s financial awakening seldom relied on national banks (i.e. with note-issuing privileges), which the imperial government stopped chartering after 1878. Non-national commercial banks grew rapidly thereafter, soon exciding the number of national establishments as the low capital requirements in the 1880s did not represent a meaningful barrier of entry. When in 1901 these requirements were raised to ¥500,000 the number had jumped from 141 to 2289 (p.145).
Another sign of the relatively free-banking policies of Japan: the number of branches went from 122 (0.87/bank) to 6287 (3.77/bank). Competition in the banking sector was thus active and well. But this development did not affect the whole country uniformly: by 1925, Tokyo had 487 (+3000% since 1884) branch offices and Okinawa only 8 (+300%).
“In Tokyo, Osaka and other centers, transfer clearinghouses arose spontaneously by 1880, and served as a venue for trading transfers between banks [but] only a few of the largest regional banks were able to participate in the network at all” (p.146). In the same way, it took 15 years for the catchment area of the telegraph to become significant after its debut in 1870 in Tokyo and Osaka thus limiting regional banks’ ability to “diversify away from idiosyncratic risk associated with local lending markets” (p.148).
The establishment of the Bank of Japan
“The bank was founded with five objectives in mind: (1) facilitate finance; (2) enhance funding of the national bank; (3) reduce interest rates; (4) offer treasury receipt and disbursement services; and (5) discount foreign bills” (p.150). The BoJ started using private sector banks as its local correspondents (150 in 1890). The system was successful enough to totally take over the transfers of the private clearinghouses by 1890 (p.151). The signing in og private correspondents had initially been favoured over the opening of branch offices of the BoJ as the latter were seen as potentially armful for the activity of local commercial establishments (p.152). But the Ministry of Finance soon recognized the need for a BoJ branching network (p.153). By 1910, there were already 10 local offices (p.155).
Results from panel model
The model designed by the authors (see below) accounts for 31% of the prefectoral variation in interest rates deviation. It confirms that the diffusion of information helped convergence (“a one standard-deviation increase in the volume of telegraph transfers per person lowered a prefecture’s lending rate by 17 base points; p.161). “Financial innovation also played a role in the convergence of interest rates; in particular, the dissemination of [BoJ’s] branch offices appears to have lowered rates for borrowers” (“one standard-deviation in the ratio of branch offices to head offices decreased lending rates by around 8 points”).
Noticeably, over the period, integration became such that ultimately no meaningful difference could be observed between Tokyo and Osaka. On the other hand, the level of local competitiveness appears to have had little impact. But more idiosyncratic factors did affect lending rates, in particular lower default risk (i.e. the borrowers’ collateral as approximated by regional land price). Thus one standard-deviation increase in the price of land brought a 43 basis points decrease relative to the mean interest rate (p.164).
The BoJ office branch of Saibu opened in 1893 (p.165). Due to specie shortage, the interest rates were ¥0.02-0.03 higher than in Osaka. After the establishment of the office branch, volume of transfer increased markedly; even major banks were using that service (p.166). In this case the BoJ helped smoothen the flow of funds with the remote regions and thus alleviate local funding bias (p.167).
The BoJ appears to have had a very positive impact on the country’s financial structure via a trail-and-error process. However the impact of financial modernity upon economic growth in Japan remains to be explored (p.168).