The Flaws in Fragile by Design: The Political Origins of Banking Crises and Scarce Credit

20 04 2014

Fragile by Design: The Political Origins of Banking Crises and Scarce Credit

Charles W. Calomiris and Stephen H. Haber (Princeton University Press, 2014).

I’ve had the chance to read and think about this important yet flawed book on the political origins of banking crises. I’m writing this blog post in the hopes of generating some debate about the book’s strengths and limitations.

Here is a summary of the book:

Why are banking systems unstable in so many countries–but not in others? The United States has had twelve systemic banking crises since 1840, while Canada has had none. The banking systems of Mexico and Brazil have not only been crisis prone but have provided miniscule amounts of credit to business enterprises and households. Analyzing the political and banking history of the United Kingdom, the United States, Canada, Mexico, and Brazil through several centuries, Fragile by Design demonstrates that chronic banking crises and scarce credit are not accidents due to unforeseen circumstances. Rather, these fluctuations result from the 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.

 

Fragile by Design is a revealing exploration of the ways that politics inevitably intrudes into bank regulation. 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.

 

 

The authors, who are distinguished academics (see biographies below), have produced a book of impressive geographical and temporal scope that covers hundreds of years of financial history and the experiences of a wide range of countries (the UK, the USA, Canada, Mexico, and Brazil).  The general theoretical framework presented in the book, the Game of Bank Bargains, is a very plausible one. It’s consistent with how many political economists think about the politics of bank regulation. Moreover, I can see how it would apply to some of the countries that weren’t the subject of cases studies in this book. (Calomiris and Haber say that their theory is true for the countries surveyed in the book and they invite other scholars to test their theory against the historical experiences of other countries). I know a fair bit about the history of banks in Hong Kong and I can tell you that their theory of the political economy of bank regulation fits well with the history of the Crown Colony. Hong Kong developed a pretty stable banking system because it had a unique political system that was both classical liberal and non-democratic. Property rights in Hong Kong were secure and populists weren’t able to much around with banking regulation since the colony was run by people like Chris Patten, not elected officials. It that sense, the Hong Kong political system was a more extreme version of the semi-democratic constitution the British gave to Canada in 1867. As Calomiris and Haber point out, that constitution was designed to limit the ability of populists to regulate business.

 

There is one important work on the political economy of bank regulation that appears to be missing from their bibliography. That’s  Admati, Anat R., and Martin F. Hellwig. The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It. Princeton: Princeton University Press, 2013.

I suspect that had Calomiris and Haber read the Admati and Hellwig book, they would have said more about capital requirements than they actually do.

I also think that the decision of the authors to ignore the issue of transnationality, which is seen throughout the book, is especially problematic with regard to the sections of the book that relate to Canada. First, bank regulation has long had a transnational element. This was particularly the case in the old British Empire, whereby officials in London sought to meddle with the banking regulations developed by colonial assemblies. Moreover, banks from the nineteenth century onwards have opened branches outside of their home jurisdictions.  Transnationality is an even more important theme today, yet it is neglected by the authors.  Calomiris and Haber say shockingly little about the tortured and complex political history of the Basel capital standards since 1988. Their discussion of the various Basel Accords is confined to pages 264, 265, and 266. I was very disappointed that the authors said so little about the diplomatic history of Basel I, II, and III– as full professors with connections to the Hoover Institution, they are in an excellent position to investigate the recent political history of transational bank regulation via interviews with key decision makers. We know from press reports and from things Admati and Hellwig have said that different national governments have worked to water-down the Basel Accords, whenever it suited the interests of their country’s banks. Germany, the USA, the UK, have all done this. I’m a pretty average academic with an average research budget. I would never be able to research this recent political history because I don’t have the connections and the budget to say, fly to Davos. Calomiris and Haber do have these resources but they squandered their opportunity to do the research and integrate it into their narrative.

 

There is another and more fundamental problem here. The authors have adopted the comparative politics approach. They analyse each domestic political system as a self-contained entity and then compare the results. That’s a legitimate approach to studying many political economy topics not to mention non-economic topics such as the politics of abortion. It is not a suitable approach for studying bank regulation since banks have long been fairly internationalised. Banking was very internationalized in the pre-1914 golden age of globalization and it’s re-internationalized in recent decades.  To be fair, the authors’ fairly insular approach may work when studying the history of banking regulation in the United States, which had a fairly self-contained banking system until quite recently. (As the authors show, interstate branching was illegal until rather recently). However, the experience of Canada, Australia, Latin America, and other settler economies was quite different– as multinational banks such as the Bank of British North America, which was headquartered in London, opened branches in a variety of jurisdictions there. Calomiris and Haber note that US states prohibited foreign and out-of-state banks from branching. They haven’t thought hard enough about what the absence of such regulations meant in Canada and the other countries that developed relatively stable banking institutions.

The authors assert that Canada became independent in 1867, repeating a common misconception about the nature of Confederation. This mistake does have relevance to their core argument, since the UK continued to exert an important influence on Canadian banking into the 20th century, even if Treasury officials in London were powerless to stop the passage of the 1851 Free Banking Act in the Province of Canada, a piece of legislation they disliked but which ended up not being very important. Moreover, the fact that Canadian banks were so-called imperial banks facilitated their entry in the British West Indian market.

The authors assert on p.264 that the Bank of Canada was created in 1935 as a gesture designed to appease farmers in the Canadian West who wanted an activist and “inflationist” monetary policy designed to help commodity producers. (The authors do not cite the source of this information). The influence of the Bank of England and Sir Charles Addis of HSBC on the design of Canadian banking legislation in the 1930s is totally ignored by Calomiris and Haber, who basically ignore the fact that the Bank of England wanted counterpart central banks throughout the Empire and its encouragement led the anglophile government of R.B. Bennett to pass the law creating the Bank of Canada in 1934.  Peter Cain has argued that the Bank of Canada was created in 1934 in part as a way of reorienting Canadian finance away from Wall Street and back to the City of London, which had been the centre of its universe before 1914.

 

The role of the British Colonial Office and, later, the JCPC in shaping the banking laws of the self-governing colonies is largely ignored here. That’s because the authors assume that making of banking legislation as something that is done within each jurisdiction’s self-contained political system. As I said earlier, that assumption holds true for the United States for almost all of its history up to at least the collapse of the Herstatt Bank in 1974. It isn’t true for jurisdictions that gained sovereignty very gradually (Canada and Australia before 1931) or which have opted to cede or “pool” a degree of sovereignty in the interests of creating trans-national banking standards (Basel Accords, 1988 to present or the members of the Eurozone in recent months).

 

The authors cite Geoffrey Jones. (1995). British multinational banking, 1830-1990. Oxford University Press. However, they appear to have ignored Jones’s research on the role of Downing Street in attempting to regulate the banking systems of the colonies. I believe that one of the reasons that Canada and Australia developed stable and highly concentrated banking systems similar to that of the UK was that a) the Colonial Office vetoed colonial bank laws that threatened to create systemic risk for the entire British Empire b) banks headquartered in London had extensive bank networks in the Dominions that largely became indigenized (the Bank of British North American was eventually acquired by the Bank of Montreal) c) people in the Dominions admired and copied British institutions, including banking.

 

There are, in my view, some important omissions from their bibliography.

 

Baster, Albert Stephen James. The imperial banks. London: P.S. King, 1929. (This source is cited and used by Jones, but not C and H).

Knaplund, P. (1950). James Stephen on Canadian Banking Laws, 1821–46. Canadian Historical Review, 31(2), 177-187.

Cain, P. J. 1996. “Gentlemanly Imperialism at Work: The Bank of England, Canada, and the Sterling Area, 1932-1936”. The Economic History Review (London). 49, no. 02: 336-357.

I read the sections of the book on British banking history with interest. It will be interesting to compare them with Professor John D. Turner’s forthcoming book Banking in Crisis: The Rise and Fall of British Banking Stability, 1800 to the Present.

 

 

Charles W. Calomiris is the Henry Kaufman Professor of Financial Institutions at Columbia Business School and a professor at Columbia’s School of International and Public Affairs. His many books include U.S. Bank Deregulation in Historical Perspective. Stephen H. Haber is the A. A. and Jeanne Welch Milligan Professor in the School of Humanities and Sciences and the Peter and Helen Bing Senior Fellow at the Hoover Institution at Stanford University. His many books include The Politics of Property Rights.

 

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