Credit crises: following the trail of crumbs

When the lending system isn’t working, interests rate a check, advises Howard Davies

February 20, 2014

“We get the banking system we deserve” would be a one-sentence summary of the 500 or so pages of Fragile by Design. A slightly longer precis might include the idea that every nation makes its own choices about the type of financial institutions it wants, about the nature of competition between them, and about the balance struck between innovation and risk, on the one hand, and safety and stability on the other. The authors describe the process of making these choices as “the game of Bank Bargains”.

The consequences of the different bargains made can be remarkably different. A comparison of the US and Canada is particularly instructive. From 1800 to 1907, there were 11 major banking crises in the US. Until the Bank of Ontario failed in 1906, there were no crises during that period in Canada, and even then the failure was so smoothly handled that depositors were barely aware of it. The essential difference between the two countries was that Canada allowed branch banking, which encouraged consolidation and concentration, while the US clung to the practice of “unit banking” (one bank, one branch), with local entities not allowed to merge with others, on the argument that local savings should be mobilised only to support local investment. Populist elected officials at state level were highly supportive of this fragile arrangement, benefiting from the naive support of local voters and the patronage supplied by the banks that benefited from the tight constraints on competition. But those unit banks proved to be extremely vulnerable to downturns in their communities.

Charles Calomiris and Stephen Haber develop their “Bank Bargain” argument through case studies covering, as well as the US and Canada, the UK, Mexico and Brazil. But their canvas is not limited to these five examples, and a concluding section attempts to produce a league table of successful banking systems, defined as those that have been crisis-free since 1970, and have been able to supply abundant credit throughout the period. The authors recognise that it is fairly easy to keep banks in being if they do not lend money or take risks, so both criteria are relevant.

Their league is topped by the countries they call the “very successful six”: Australia, Canada, Hong Kong, Malta, New Zealand and Singapore. At this point, the breasts of British imperialists swell with pride. The authors acknowledge that common imperial heritage, but attach less importance to blue royal blood than to the fact that “the structure and political histories of these countries tended to mitigate the ability of populists and bankers to form coalitions that disadvantage everyone else”. That applies strongly to the three major countries, while the city states on the list have other competitive advantages.

This broad cross-country analysis is the most interesting theme of Fragile by Design. The authors are right to argue that the interface between banking and politics is crucial to an understanding of why some banks fail. But there is another argument, related specifically to the origins of the financial crisis in the US. For Calomiris and Haber, the real villains of the piece are the federal government-backed agencies Fannie Mae and Freddie Mac, together with the legal obligations on banks to lend in poor areas under the Community Reinvestment Act. These state-originated interferences in the market served to distort incentives, and cause risk to be mispriced. This the authors see as the “original sin” of the US financial system. They reject the notion that the combination of lending and securities trading was a contributory factor, thus dismissing the arguments that lie behind the Vickers report published by the UK’s Independent Commission on Banking at the end of last year, and subsequent legislation to create ring-fences within the universal banks, to limit contagion from one type of business to another. They see no evidence that universal banking was a weakness in the recent crisis, or indeed in the 1920s.

Theirs will not be the last word in the continuing debate. For my money, they attach too little significance to the choices bankers make – even in the worst-designed systems, some banks succeed. But Calomiris and Haber offer a thoughtful counter-argument to the current received wisdom.

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