The effect of marijuana legalization on small bank competitive advantages

Abstract

Federal regulation requires that banks have specialized and sophisticated tools to prevent, identify, and record money laundering. Cash generated in states where recreational marijuana is legalized qualifies as illicit at the federal level. As such, the increase of marijuana cash in the market represents an increase in money laundering risk, to which banks must respond according to regulatory expectations. Because of scale advantages and the relationship-based nature of their transactions, small community banks may face greater constraints in responding to this risk relative to medium-to-large banks. To test this, I observe 105 banks over 12 years during a time when recreational marijuana legalization occurred in four states. I estimate bank performance with a non-parametric linear programming approach of data envelopment analysis. With marijuana legalization and bank size regressed on these measures of performance, and controlling for bank and year fixed effects, I find that small community banks in marijuana states are, on average, further from the best practice frontier relative to medium-to-large banks.