Fragile By Design

Charles W. Calomiris & Stephen H. Haber “Fragile By Design: The Political Origins Of Banking Crises & Scarce Credit,”  Princeton Univ. Press, 2014, 506 pp.

Here is a book all bankers should read as it provides a useful history of banking over the last couple of centuries and the role played by politics in that evolution.  This book clearly shows why some countries are so much more prone to bank crises than others.  Why, for example, has Argentina had four in the last 40 years and Australia none?  Why have the United States and Canada—two countries that have a common culture and similar legal arrangements, and that share a fundamental belief in free-market capitalism—had such different experiences with their banking industries?  For instance, since 1840 the United States has had 12 systemic banking crises and Canada has had none. The authors’ simple answer: It all has to do with politics.  Understanding how outcomes vary in the Game of Bank Bargains is a central purpose of this book.

This authors provide a framework for understanding how political factors shape banking-system outcomes, they analyze the political and banking history of the United Kingdom, the United States, Canada, Mexico, and Brazil through several centuries.  The authors’ demonstrate that chronic banking crises and scarce credit are not accidents due to unforeseen circumstances.  Rather, these crises result from complex bargains made between politicians, bankers, bank shareholders, depositors, debtors, and taxpayers.  The well-being of banking systems depends on the abilities of political institutions to balance and limit how coalitions of these various groups influence government regulations.  In the U.S., because of the way our politics interact with the banks, our banking system ranks way down in the international league tables for safety, alongside countries like the Philippines, Thailand, Turkey, Spain, Sweden, Ecuador, Brazil, Mexico, Colombia, Costa Rica, Chile, Uruguay and Bolivia.

My Notes: 

Pg. x:  The authors began this book to explore three fundamental questions about banking. Why are some societies able to construct banking systems that avoid banking crises, while others are not?  What makes some societies limit the right to charter a bank to a favored few, even though doing so limits the availability of credit to broad swaths of the population?  Why do societies sometimes fail to protect the property rights of lenders, depositors, and bank stockholders which then undermines the ability of banks to raise funds or lend funds?

Pg. 4:  Systemic bank insolvency crises like the U.S. subprime debacle of 2007-09 occur when banking systems are made vulnerable by construction, as the result of political choices (bargains).  Banks are susceptible to collapse only when they both expose themselves to high risk in making loans and other investments and have inadequate capital on their balance sheets to absorb the losses associated with those risky loans and investments.  The U.S. is highly crises prone, it has had major banking crises in 1837, 1839, 1857, 1861, 1873, 1884, 1890, 1893, 1896, 1907, the 1930s, 1930-33, the 1980s, and 2007-09.  Canada, on the other hand, has had no systemic banking crises since its independence in 1867.

 Pg. 7:  There is, of course, more to having a good banking system than simply avoiding crises.  Equally problematic are banking systems that provide too little credit relative to the size of the economy.  Consider the contrast between Canada and Mexico.  From 1990 to 2010, private bank lending to firms and households averaged 95 percent of GDP in Canada, but in Mexico the ration was only 19 percent.  The difference in those ratios means that Mexican families have a much more difficult time financing the purchase of homes, autos, and consumer goods.  The result is slower economic growth.  Little wonder, then, that over 500,000 Mexicans—roughly half of all new entrants to the Mexican labor market—illegally cross the border to the U.S. each year.

Pg. 13:  The fact that the property-rights system underpinning banking systems is an outcome of political deal making means that there are no fully ‘private’ banking systems; rather, modern banking is best thought of as a partnership between the government and a group of bankers, a partnership that is shaped by the institutions that govern the distribution of power in the political system.  Government policies toward banks reflect the deals that gave rise to those partnerships, as well as the power of the interest groups whose consent is crucial to the ability of the political group in control of the government to sustain those deals.

 

Pg. 54:  Populists, whose philosophical origins date back to Jean-Jacques Rousseau, believe that the function of voting is to allow society do divine the popular will and that satisfying the popular will is a moral imperative: it is inherently right and should be respected by government and embodied in social policy. 

Pg. 55: Populists have a very different conception of freedom from liberals.  In the liberal conception, freedom is enjoyed by individuals and is defined by the absence of tyranny; in the populist conception, freedom means the ability to use government to implement the collective will of the people.  All democratic political systems contain both liberal and populist elements.  The U.S. liberal constitution has always contended against a strong populist countercurrent.  However, with the election of Andrew Jackson populism became more pronounced.  (Jackson even ignored a ruling of the Supreme Court because it was inconsistent with the popular will to expropriate the lands of Native Americans.)  Other prominent examples of politicians tapping into broad populist sentiment in order to advance diverse personal and ideological goals include William Jennings Bryan’s Populist Party, Franklin Roosevelt’s New Deal, Richard Nixon’s ‘silent majority,’ former House speaker Newt Gingrich’s calls for the arrest of activist judges, and the speeches of Obama denouncing ‘Wall Street fat cats.’ 

Pg. 78:  Bismarck, to prevent the socialists from coming to power and overturn the political order he was establishing, led the world in creating national programs to provide old-age pensions, public medical care, and unemployment and industrial accident insurance.

Pg. 99:  The French Revolutionary Wars and the Napoleonic Wars required a rethinking of the bank’s role in public finance.  These wars were like none the British had fought previously because of a crucial French innovation: the forced mass conscription of the adult male population.

Pg. 137:  The election of July 1945 gave the Labour Party in Britain a majority in Parliament for the first time in British history.  Labour embarked on a broad program of nationalizing industries.  They nationalized the Bank of England in 1945 (but not the private banks); the coal mines, civil aviation, and transport in 1946; electricity generation and distribution in 1947; gas distribution in 1948; and the iron and steel industry in 1950. 

Pg. 153:  Governments always get their share of the benefits from playing the Game of Bank Bargains and the United States is no exception.  From the tie of the Revolutionary War until the 1810s, the dominant coalition was composed of political elites in both federal and state governments, many of whom were members of the Federalist Party, allied with a narrow group of financiers.  This coalition of elites is best exemplified by its intellectual architect, Alexander Hamilton.  Because this coalition limited the number of banks that received charters, it tended not to provide credit to small farmers and artisans.  This coalition of the elites gave way in a second era which ran from the 1810s to roughly 1980, to a durable alliance between small unit bankers (operating banks with no branches) and agrarian populists (farmers who distrusted corporations of nearly every type).   

Even the Great Depression was unable to break the populist collation that supported this inefficient and unstable banking system.  Rather, the agrarian populist unit banker coalition used the depression to create a new set of institutions designed to prop up what was fundamentally a system that was fragile by design.  These institutions included deposit insurance and a set of laws including the notorious Regulation Q that made it illegal for banks to pay interest on checking accounts and limited the interest rates they could pay on other types of accounts.  These institutions could work only if the government remained committed to conservative monetary and fiscal policies.  Once the U.S. government began to depart from those policies in the 1960s, and inflation accelerated through the 1970s, the interest rates that could be legally offered by banks turned negative (inflation exceeded the interest rates offered on deposits), and the public pulled out their money and placed it with various bank competitors, such as money market mutual funds.  The invention of ATMs in the 1970s, further undermined the system by allowing banks to skirt laws against branching.  Thus by the 1980s, the conditions that had permitted a stable unit-bank system had crumbled.  The result was the savings and loan crisis of the late 1980s.  In the 1990s, for the first time in U.S. history—and centuries after they appeared in other countries—large banks with nationwide branching networks were allowed to form.

Pg. 155:  The fact that a coalition of farmers and small bankers was able to dismantle the banking institutions that had been set up by Alexander Hamilton, and that it was then able to establish an inefficient and unstable alternative that endured for more than 150 years, implies that something about this coalition was woven into the fabric of America’s political institutions. 

Pg. 190:  Although the civics textbooks used by just about every American high school portray deposit insurance as a necessary step to save the banking system during the Great Depression, all of the evidence indicates otherwise: it was the product of lobbying by unit bankers who wanted to stifle the growth of branch banking.  First, the banking crisis of 1932-33 ended months before the establishment of FDIC insurance.  Second FDR opposed deposit insurance: he was familiar with the disastrous experience of state-level experiments with deposit insurance during the early 1920s.  Also, Senator Carter Glass and the banking committee, who drafted the initial legislation, were also opposed.  They added it at the eleventh-hour to get the support of the populist chairman of the House Banking Committee, Representative Henry Steagall.  It originally only covered small deposits; it was broadened to include larger deposits several years later, well after the banking crisis had ended.

Pg. 193:  Housing prices nationwide fell by an average of 33 percent from 1930 to 1934.  Mortgages at that time were mainly three- or five-year interest-only loans that ‘ballooned’ at maturity, with typical loan-to-value ratios of about 50 percent; thus the declining incomes of homeowners and the fall in house prices put many people at risk of losing their homes. 

Pg. 202:  The final blow to the unit banks came in 1994, when Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act.  Banks could now branch both within states and across state lines. This was the death knell of the unit banker-agrarian populist coalition that had shaped American banking institutions since the 1830s.

Pg. 207:  How did it come to pass that in 1990 a mortgage applicant needed a 20 percent down payment, a good credit rating, and a stable, verifiable employment and income history in order to obtain a 30-year fixed-rate mortgage, but by 2003 she could obtain a high-risk, negatively amortizing adjustable-rate mortgage by offering only a 3 percent down payment and simply stating her income and employment history, with no independent verification?

Pg. 278:  Academics generally agree that there are three sets of key problems to resolve to ensure another 2007-08 crash does not recur.  First, banks must be required to manage their risks more prudently, hold more capital, and recognize losses in a more timely manner.  Second, government mortgage policies must be reformed to end the destabilizing subsidization of risky mortgage lending through Fannie, Freddie, and the FHA.  Third, large financial institutions must be prevented from free riding on too-big-to-fail protection.  Unfortunately Dodd-Frank does not offer much hope for solving these problems.

Pg. 280:  The subprime crisis was, first and foremost, the outcome of a political bargain.  Since the 1980s, and accelerating through the 1990s and 2000s, banks, along with GSEs, were allowed to grow into enormous enterprises.  This expansion afforded them increased economies of scale, economies of scope, potential for market power, and levels of too-big-to-fail protection.  In exchange, they had to share some of the resulting rents with activist groups—a move that policy makers saw as a politically easy way to address the serious social and economic problems that affected America’s urban poor.  Activists used their influence in Congress in the banks’ favor to impose HUD mandates on Fannie and Freddie mortgage purchases and to force Fannie and Freddie to loosen their underwriting standards.  Fannie and Freddie went along on condition that they were granted the right to finance their mortgages and mortgage-backed securities with money that they borrowed, with an implicit guarantee of their debts coming from taxpayers.

Pg. 458:  It is apparent with few exceptions that there is a general pattern to countries with stable banking systems.  These countries provide abundant credit and tend to be stable democracies with institutions that limit the opportunities for bankers and populists to form rent-seeking coalitions.  Countries with unstable banking systems, on the other hand, provide low levels of credit and tend to either be autocracies, democracies of very recent vintage, or democracies in which the institutions that limit rent seeking are weak.

Pg. 461:  One of the major lessons emerging from the author’s study is that government safety nets for banks, such as deposit insurance, actually tend to be destabilizing.  These safety nets emerged not because they were economically more efficient but as the outcomes of political bargains.  Indeed, the notion that deposit insurance, bailouts, and other government-provided support are essential for stabilizing banks is belied by Canada’s experience: despite the highly cyclical nature of the Canadian economy and the absence of deposit insurance for most of its history, Canada has never experience a significant banking insolvency crisis.  (In 1980, only 20 countries guaranteed deposits; by 2003, 87 countries did.)