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Finance and the Efficiency of Capital Allocation: Do BankBranching Regulations Matter?

Over the past decade, an extensive literature in international finance has confirmed the role of financial development as an important catalyst for growth and allocative efficiency. A common thread running through most of this literature is the focus on the level of investment returns. In striking contrast, the literature in finance on mean-variance efficiency and the capital asset pricing model suggests that the variance-covariance properties of returns should play an equally crucial role in the allocative efficiency of investment.

Inspired by this literature, we introduce in this paper a measure of the portfolio efficiency of investments in the real economy. Specifically, we calculate the efficient production frontier of an economy, on the basis of both the mean and the variance-covariance structure of returns on investment indifferent industries of the economy. The method also gives rise to a measure of the efficient Sharperatioand the corresponding weights on investments indifferent industries.

Inspired by this literature, we introduce in this paper a measure of the portfolio efficiency of investments in the real economy. Specifically, we calculate the efficient production frontier of an economy, on the basis of both the mean and the variance-covariance structure of returns on investment indifferent industries of the economy. The method also gives rise to a measure of the efficient Sharperatioand the corresponding weights on investments indifferent industries.

Our laboratory for answering these questions consists of state-level production at the sector level, and banking deregulation in the United States. We treat each state in the U.S. as an individual economy and study how relaxing state branching restrictions for banks within and between states has affected theallocative efficiency of states production patterns.

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Finance and the Efficiency of Capital Allocation: Do BankBranching Regulations Matter?