In the early 1900s, a banker could help finance a company while sitting on its Board of Directors.

This seems weird. Today, we have laws and policies to regulate conflicts of interest, but were these financial relationships actually that bad?

Carola Frydman and Eric Hilt say no. In a new paper in the American Economic Review, they look at the aftermath of Section 10 of the Clayton Antitrust Act. The Section made banker directorships illegal when it passed in 1921.

The findings push back against the theory that bankers, hoping to earn higher fees, persuaded companies to make unnecessary and reckless investments.

The figure below shows how Section 10 affected railroad companies with conflicts of interest.

Panels A and C of Figure 3 from Frydman and Hilt (2017)

Tobin’s Q, a measure of the company’s value, plummeted just as interest rates rose. These indicators suggest that companies lost access to funding for legitimate projects. If bankers had been profiting at a railroad’s expense, the value of the railroad company would have increased, and the interest rates would have dropped.

Banks only knew how trustworthy the railroads were from being on their Boards. Without this information, they became reluctant to finance the companies, even when the projects would have benefitted the public.

As it turns out, the conflict of interest had been helping everyone — the bankers, the railroads, and the public — all along.