February 28, 2014

Everything is Political

Bank crises are the product of governments, not market events, say Charles Calomiris and Stephen Haber in their new book.

Charles Calomiris & Stephen Haber
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In their new book, “Fragile by Design: The Political Origins of Bank Crises and Scarce Credit,” Charles Calomiris and Stephen Haber combine political history and economics to examine how coalitions of politicians, bankers, and other interest groups form, why some endure while others are undermined, and how they generate policies that determine who gets to be a banker, who has access to credit, and who pays for bank bailouts and rescues. In this excerpt, the authors outline the premise of their argument that banking systems are only as strong as the policies that regulate them.

Everyone knows that life isn’t fair. That “politics matters.” We say it when our favorite movie loses out at the Academy Awards. We say it when bridges to nowhere are built because a powerful senator brings federal infrastructure dollars to his home state. And we say it when well-connected entrepreneurs obtain billions in government subsidies to build factories that never stand a chance of becoming competitive enterprises.

We recognize that politics is everywhere, but somehow we believe that banking crises are apolitical, the result of unforeseen and extraordinary circumstances, like earthquakes and hailstorms. In that story, well-intentioned and highly skilled people do the best they can to create effective financial institutions, allocate credit efficiently, and manage problems as they arise — but they are not omnipotent. Unable to foresee every possible contingency, they are sometimes subjected to strings of bad luck. Economic shocks, which presumably could not possibly have been anticipated, destabilize an otherwise smoothly running system. Banking crises, according to this version of events, are much like Tolstoy’s unhappy families: they are all unhappy in their own ways.

[But] systemic bank insolvency crises like the United States subprime debacle of 2007–2009 — a series of bank failures so catastrophic that the continued existence of the banking system itself is in doubt — do not happen without warning, like earthquakes or mountain lion attacks. Rather, they occur when banking systems are made vulnerable by construction, as the result of political choices.

If such catastrophes were random events, all countries would suffer them with equal frequency. The fact is, however, that some countries have had many, whereas others have few or none. The United States, for example, is highly crisis prone … with 14 banking crises over the past 180 years! Canada, which shares not only a 2,000-mile border with the United States but also a common culture and language, had only two brief and mild bank illiquidity crises during the same period, in 1837 and 1839, neither of which involved significant bank failures.

Spreading Risk

A broad literature in financial economics has demonstrated that a system in which shareholders and depositors have money at risk imposes discipline on the behavior of bankers: at the first sign of trouble, stockholders start selling their shares, and depositors start moving their funds to more solvent banks. As a result, some banks fail, some of the holders of bank liabilities (shareholders and depositors) are wiped out, credit contracts as bankers rush to reduce their exposure to risky classes of loans, and economic growth slows.

The result is painful, but not tragic. Most important, bankers know the consequences of imprudent behavior and thus tend to maintain large buffers of capital and large portfolios of low-risk assets. As a consequence, systemic banking crises are rare. Contrast that outcome with the system that has come to be the norm since the mid-twentieth century. Until [then], the costs of failure tended to be borne by the bankers themselves, along with bank shareholders and depositors. Since then, however, the costs have been progressively shifted to taxpayers.

When losses are borne by taxpayers, the incentives of stockholders and depositors to discipline bankers are much weaker. Bankers are willing to take bigger risks, thereby increasing the probability of failure. As a result, after 1945 banks in the world’s most developed economies became more highly leveraged and maintained smaller amounts of low-risk assets.

The Grand Bargain

In most countries, banks are regulated much like public utilities such as electricity generation: entry to the market is controlled by government agencies in order to assure that the firms providing the service remain profitable, and the government inspects their operations to make sure that they are providing efficient service to their customers while not taking imprudent risks. The struggle among political coalitions determines who gets to play what roles in the financial system; that is, who is granted what kind of banking charter, and which groups of borrowers get government-favored access to credit. A central aspect of the Game of Bank Bargains, therefore, is deciding the rules for entry into banking.

There is no escaping the Game of Bank Bargains: politics always intrudes into bank regulation. [One crucial example from the most recent crisis] was when the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which repurchased and securitized mortgages, were pressured by the Clinton administration to lower their underwriting standards dramatically so that these loans could become part of Fannie and Freddie’s portfolios. Once they consented to doing so, their progressively weaker underwriting standards applied to everyone.

We cannot stress this point strongly enough: the politics of regulatory approval for bank mergers set in motion a process whose ultimate outcome was that large swaths of the American middle class were able to take advantage of mortgage-underwriting rules that, compared to those of any other country in the world and of earlier periods of America’s own history, were inconceivably lax.

The subprime lending crisis was simply the latest in a very long string of American banking crises. What must be explained is why the United States has a banking system that is so persistently crisis prone. What is it about American political institutions that generates incentives for bankers and populists to search one another out and forge such powerful coalitions?

Our answer to this question is that the fragility of banks and the scarcity of bank credit reflect the structure of a country’s fundamental political institutions. The crux of the problem is that all governments face inherent conflicts of interest when it comes to the operation of the banking system, but some types of government — particularly democracies whose political institutions limit the influence of populist coalitions — are better able to mitigate those conflicts of interest than others.

Adapted from Fragile by Design: The Political Origins of Banking Crises and Scarce Credit by Charles W. Calomiris and Stephen H. Haber. (c) 2014 by Princeton University Press. Reprinted by permission.

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