Financial Integration and the Co-Movement of Economic Activity: Evidence from U.S. States

We analyze the effect of the geographic expansion of banks across U.S. states on the co-movement of economic activity between states. To identify the causal effect of financial integration on business cycle synchronization, we exploit the staggered timing of the removal of restrictions to interstate banking to construct time-varying instrumental variables at the state-pair level. We find a strong positive effect of bilateral banking integration on the synchronization of economic activity between states, conditional on national shocks and state pair heterogeneity. This effect is stronger for states experiencing periods of financial turmoil and for industries that rely more on external financing. Furthermore, we find that integration increases the similarity of fluctuations in bank lending between states. Our findings are consistent with theories highlighting the role of banks in transmitting financial shocks across regions, and show that integration has increased output synchronization between U.S. states.