FragileByDesign

Fragile by Design (Charles Calomiris and Stephen Haber)

  • Good. Learned a lot of history and a broad prospective on the purpose of banks.
  • Banks are really an institutional embodiment (a mirror of sorts) of the political system that is a product of the societies deep history. (the banking system is not a product of moral failure of bankers)
  • This book takes the view that politics that we see operating everywhere else around us also determine banking crises. Banking crises are not apolitical, or the result of unforeseen and extraordinary circumstances like natural disasters.
  • a country does not "choose" its banking system: rather it gets a banking system that is consistent with the institutions that govern its distribution of political power.
  • If bank crises were random events, all countries would suffer them with ~equal frequencies. The fact is that some countries have had many, while others have had few or none. The US is highly crises prone (14 crises over the past 180 years) Canada which shares a border and common culture and language, had only two brief and mild bank illiquidity crises during the same period.
  • Equally problematic are banking systems that provide too little credit relative to the size of the economy "under-banking"
  • Until the mid 20C, the costs of failure tended to be borne by the bankers themselves, along with the shareholders and depositors. Since then, however, regulators and politicians come to impose these costs on taxpayers. Why do taxpayers put up with bearing those costs? Especially puzzling because shifting of losses onto taxpayers tends to produce much larger losses and deeper recessions than a system in which shareholders and depositors bear the cost. When shareholders and depositors have money at risk they impose discipline on the behavior of the bankers.
  • If stable and efficient banks are such a good idea, Why are they so rare? How can it be that a sector of the economy that is highly regulated and closely supervised works so badly in so many countries ? Our answer is that the fragility of the banks and the scarcity of bank credit reflect the structure of a countries fundamental political institutions.
  • The fact that the property-rights systems underpinning banking systems is an outcome of political deal making means that there are no fully private banking systems. Modern banking is best thought of as a partnership between the government and a group of bankers.
  • Banks are regulated and supervised according to technical criteria, and banking contracts are enforced according to abstruse laws, but those criteria and laws are not created and enforced by robots programmed to maximize social welfare; they are the outcomes of political processes – a game – whose stakes are wealth and power.
  • It is rarely the case that a government chooses a fully "open-access" bank chartering system. Being selective about who gets to be a banker and deciding how much bankers are allowed to lend and to whom are crucial elements of the game.
  • Our goal in this book is to explain this game. We seek to understand the process by which different rules emerge in different countries and how the players operate within those sets of rules. We show how differences in fundamental political institutions produce differences in the rules of the game, and how those politically based rules sometimes result predictably in stable and plentiful bank credit, and sometimes in unstable and scare bank credit, and sometimes (as in the US) in unstable and plentiful bank credit.
  • The idea that banking systems can exist outside a system of government regulation is simply a libertarian fairy tale.
  • Until very recently all US banks were prohibited from having branches in more than one state. Until the 1970s most US states had laws that prevented banks from opening multiple branches even within the state.
  • The politics of regulatory approval for bank mergers set in motion a process wholes 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 in America's own history, were inconceivably lax.
  • Financial markets have always been created and sustained by banks.
  • A bank is, by design, a potentially unstable enterprise.
  • This instability arises because the normal functioning of banks depends on three sets of property rights that only government can provide.
  • There is no avoiding the government-bank partnership.

  • What outputs does a bank produce ? and what inputs does it consume? The major outputs of a bank – its products – are debt contracts, primarily in the form of IOUs payable to the bank. The major inputs to the bank are also contracts, primarily in the form of IOU payable to depositors. The banks basic business model is therefore unusual: its input and outputs are both loans.

    Any enterprise whose inputs and outputs consist primarily of promises to repay debts in inherently unstable and risky. Bankers must engage in a difficult balancing act. They cannot predict with certainty that the debtor will repay the loan. It is extraordinarily difficult, if not impossible, for bankers to exactly match the durations of their contracts with depositors and debtors.

  • The bank insiders need outsiders to invest their wealth in the bank in order to make the bank stable enough to attract depositors, but in doing so the insiders transfer the risk from depositors to equity investors.
  • The government has a conflict of interest when it comes to banks: it simultaneously regulates them, borrows from them, or taxes them.
  • Deposit insurance destabilizes the banking system. Depositors no longer have an incentive to discipline the bank insiders b/c their funds are no longer at risk. The insiders are now free to make riskier bets.
  • The burden of inflation tax falls disproportionately on the poor.
  • Liberal believe the function of voting is to control the officials and no more. Elections allow voters to replace corrupt or venal public officials and thus constrain tyranny. There is nothing inherently good, wise, or just about the choices made through voting. Unless there are institutions that allow minorities to veto majorities, mass suffrage can, paradoxically, undermine the very goal of democracy – the existence of a free and just society. Freedom is enjoyed by individuals and is defined by the absence of tyranny; in the populist conception, freedom means the ability to use the government to implement the collective will of the people.
  • In the worlds older democracies – those established in the 18 and 19C – liberal elements tend to carry considerable weight, b/c those democracies were set up as replacements for monarchic systems that were almost synonymous with tyranny.
  • Bankers in a populist government have a perverse option in the game of banking: they can join the populists in a coalition in favor of debtor relief. Doing so puts them in a position to ask for a government bailout in the short run and deposit insurance in the longer run. Both measures transfer losses associated with debt forgiveness away from banks and onto taxpayers.
  • Chartered banks and nation-states emerged at the same time. This was not a coincidence. The two institutions co-evolved b/c banks help align the incentives of three groups crucial to the creation of viable states: rules, merchants and financiers. Merchants needed a powerful entity – a state – that could defend their expanding trading routes and enforce their contracts. Rulers needed merchants to build the commercial networks that glued their states together and sustained their overseas empires. Both merchants and rulers needed financiers. Financiers needed a state to enforce contracts with one another with merchants and with foreign states.
  • Two factors appear to have been crucial in determining which states emerged as dominant: access to the Atlantic and the ability to forge durable partnerships with the social and economic groups that carried out trade and financed the state. A lack of access to the Atlantic probably explains why the city-states of Venice and Genoa failed to keep up with the state and empire building enterprises of Spain, Portugal, France Britain and the Dutch Republic.
  • Empire building was an expensive undertaking. Europe's rules subcontracted much of the business of conquest, colonization and trade to private companies. The conquests of the Aztec and Inca empires had been carried out by private companies: the conquistadors were shareholders, more of whom had never swung a sword before.
  • Paper currency was originally invented (in Amsterdam) as a means of fighting inflation from people clipping gold and silver coins. In one of history's supreme ironies, governments soon figured out haw to turn the ability to issue paper money into a new fiscal tool – the inflation tax – a means of forcing people to suffer erosion of the value of the wealth they held in the form of cash assets to the benefit of the government.
  • Universal male suffrage and the rise of trade unionism and labor parties politicized monetary and fiscal policy-making. The rise of the welfare state and the post WWII commitment to full employment sharpened the trade-off between internal and external balance. This shift … diminished the credibility of the authorities resolve to defend the currency peg.
  • The bank of England was a monopoly set up to finance a government that spent more that it taxed and which was therefore willing to trade a set of lucrative privileges to a group of financiers in exchange for loans to the government.
  • When the dust settled at the end of the Napoleonic Wars in 1815, there was only one world power: Britain. France had been vanquished and would never threaten Britain again.
  • What varies across democracies is the extent to which they give minorities power beyond their numbers.
  • The Thatcher government proved that a majority of citizens would support a reform program with front-loaded social costs and long-term social gains, one that reduced government spending and redistribution in the name of promoting growth. Refutes that quote that "the majority will always vote for the candidates who promise the most benefits from the public treasury, with the result that every democracy will collapse due to loose fiscal policy."
  • The fact that a coalition of farmers and small bankers was able to dismantle the banking institutions set up by Alexander Hamilton, and that it was 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 Americas political institutions.
  • The 13 colonies that were to become the US were a backwater surrounded by hostile neighbors. In order to be viable the 13 colonies had to be an armed camp. They had no obvious source of wealth to pay for a large standing army. The one thing that they did have was endless expanses of farmland suitable for tobacco, corn and wheat – provided those lands could be cleared of Indians. The combination of these factors – hostile neighbors abundant land, and storable crops that could be grown on small production units – meant that British America was a society of small free holding farmers who were armed to the teeth.
  • Americas common people were therefore able to achieve something that no group of small farmer had achieved since the Roman Republic: the right to vote. Americas colonies might have had governors appointed by the King, but they also had colonial assemblies – houses of Burgess – that were popularly elected.
  • When Americas colonial elites decided to move for independence, they had to mobilize this class of armed independent farmers against the British. That was no easy task: they were asking them to go toe to toe against the most disciplined and best-equipped army in the world. Motivating them to do so required appeals to liberty, freedom, and equality. Once these had been offered, there was no putting the genie back in the bottle. The process of revolution was a profoundly radicalizing process. After independence, to the shock of America's elites, the farmers who Washington led to victory would no longer defer to their social betters in politics. Household employees now refused to use the terms master and mistress in addressing their employers, but adopted the word boss instead. Not surprisingly within a few decades of independence the successors of the group of gentleman who led the country in revolution were pushed out of the way in the populist election of Andrew Jackson.
  • States had fiscal incentives to create bank charters and to do whatever necessary to maximize the value of the charters. They thus enabled monopolies within state boarders. Since they received no charter fees from banks incorporated in other states, they prohibited interstate banking. Banking in the early republican US was characterized by segmented monopolies.
  • The civil war led to the creation of the US; first government-issued paper currency that had the status of legal tender. Until 1861 the dollar was defined only as a given amount of gold or silver. The medium of exchanges was gold and silver coins produced at the US mint. Paper money was issued by private banks and did not have the status of legal tender. In 1862 the federal government issued US note "greenbacks" a paper currency with the status of legal tender, which could not be converted in to gold or silver.
  • The creation of the FDIC was designed to prop up unit banks and preserve their monopoly rents by insulating them from competition. Although touted as a necessary step to save the banking system, all the evidence indicates otherwise: it was the product of lobbying by unit bankers who wanted to stifle the growth of branch banking.
  • The populist-unit banker coalition was so strong that it turned the financial panics of the 19C and the great depression to its advantage. These shocks did not end unit banking, but resulted in the Federal Reserve, deposit insurance, and laws that capped the bank interest rate. They even convinced the public that these institutions had been created to protect them from avaricious big city bankers eg: Its a Wonderful Life.
  • "The genius of you Americans is that you never make clear-cut stupid moves, only complicated stupid moves which make us wonder at the possibility that there may be something to them that we are missing" – Gamal Nasser
  • 1994 marked the end of the barriers to interstate banking. The US was now in a position to have a banking structure that was not fragile by design.
  • The subprime crisis was notable not just for the spectacular magnitude of the economic collapse it caused but also for the unprecedented steps that the FED and US government took to head off the economy's downward spiral. Quantitative easing – essentially printing money in order to buy government debt
  • The Fed and the treasury account for the vast majority of American mortgage funding.
  • How was a system that should have been made more stable by consolidation become spectacularly less so? Everyone agrees that the crisis was led by "subprime" loans.
  • Banking systems are susceptible to collapse only when two conditions are met in combination: banks must take on sufficient risk and they must have inadequate capital to absorb the losses.
  • The acceptance of higher mortgage risk and low levels of bank and GSE capital were both essential aspects of a political bargain. Once branching limits were removed bankers had ambitious plans for mergers. These plans were subject to political constraint.
  • We cannot emphasis this fact strongly enough: when Fannie and Freddy agreed to purchase loans that required only a 3 percent down payment, no documentation of income or employment, and a far-from-perfect credit score, they changed the risk calculus of millions of American families, not just the urban poor. With new underwriting standards, middle class families could leverage up and buy a much bigger house in a nicer neighborhood.
  • The power of a political coalition is precisely the power to get a public official to go along with something that he knows is not in the long-run public interest because it is in his own short-term interest.
  • The US was unusual in deciding to address inequality and urban poverty through bank regulation. Western Europe increased the scope of welfare programs. The political concessions made to the urban poor in the US were to "let then eat credit". This was explicitly championed by Bill Clinton.
  • The CRA (Community reinvestment act) compliance had real costs: banks were forced to make loans that they would not have made otherwise. This misrepresented invisible taxes and transfers of wealth as nonexistent ones.
  • The new US banking bargain combined new and unlikely partners. It began as a rent-sharing game between activist groups and regional banks looking to merge to become national mega-banks.
  • Large parts of Americans middle class were able to take advantage of mortgage underwriting rules that, compared to any other country in the world or to America's own history, were inconceivable lax. The result was the rapid growth of mortgages with high probabilities of default.
  • The problem was not lack of regulation, just piles and piles of ineffectual regulation.
  • Inflated ratings of subprime-related securities were based on risk models with two key assumptions that are laughable: that an absence of income or employment documentation was not associated with higher levels of default risk, and that housing prices could never fall.
  • The subprime crisis was first and foremost, the outcome of a political bargain. 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, but only on condition that they were granted the right to finance their mortgages with money that they borrowed, with an implicit guarantee of their debts from taxpayers. This was not a partisan issue: it is perhaps better described as a urban versus rural issue.
  • Since 1840 the US has had 12 major banking crises while Canada has had none – not even during the great depression. This is especially remarkable given that Canada is a staples-based economy, heavily reliant on exports, and thus at the mercy of international variations in trade. This stability was accomplished with little government intervention.
  • A single overarching factor shaped Canada's political economy: Britain's determination to hold onto Canada as a colony. Following the American revolution this goal appeared difficult because the vast majority of the Canadian population in the late 18C was of French origin. Nevertheless Britain succeeded.
  • The difficult problem of empire – crafting colonial political institutions so that the French population of Quebec could not hold up the economic development of the interior – gave rise to a system in which the central government had a monopoly in the right to charter banks. The fact that much of its natural-resource wealth, including its best farmland, was buried deep in the interior and was geographically contiguous with the US, made managing the large French-origin population even more problematic. Contrast this with the 13 colonies who all had direct access to the Atlantic and thus independent opportunities for trade; the action of any one of them had little effect on the others ability to trade with the rest of the world.
  • To limit the power of the French in Quebec, any power not specifically delegated to the provinces was left to the national government: this arrangement was the polar opposite of the US system.
  • The long reach of initial conditions. Canada's natural resources – wheat lands, forests, and mineral deposits – were located in isolated regions, separated by vast areas. The goal of Canadian merchants was to move raw materials across Canada to Great Britain.
  • In a banking system with no restrictions on branching and no deposit insurance, there is a strong push toward consolidation. Depositors tend to favor the banks that they view as the most solvent, which also tend to be the most widely diversified and largest banks. Single-office or less prudently run banks tend to be acquired or to fail. This process had been short-circuited in the US by state laws that prevented banks from opening branches; the resulting system of unstable unit banks was then propped up by the creation of the Federal Reserve in 1913.
  • In the US a colonial elite of self-made men mobilized and led a literate, property-owning citizen army against British rule. In Mexico, a European colonial elite, fearing what would happen to them if the mass of illiterate and impoverished Indians and gained power, joined with the Spanish and their army to put down a popular independence movement that sprang up in 1810.
  • The PRI in Mexico created one of the most powerful, centralized and enduring authoritarian governments in the 20C. Part of its genius was that it wrapped all of this control in the mantle of social justice while actually giving the population almost no political voice.
  • Because of the radically uneven distribution of capital in Brazil, the Brazilian government has had to choose among three unattractive options: tax n one, and remain poor and weak; tax the poor via inflation, and become dangerously unpopular; or tax the rich and risk being overthrown immediately. Weak autocrats, who find it difficult to enforce the collection of taxes from producers and consumers, have far greater success collecting the inflation tax through bank chartering for a simple reason: banks cannot operate without the active assistance of the government. Banks are dependent even on weak governments in ways that non-bank enterprises are not. That essential difference explains why inflation taxation is so appealing to weak autocrats.
  • For most of its history, Brazil was not so much a country as a number of independent pockets of settlement, strung out along thousands of miles of coastline, isolated by the Brazil current, which made northerly travel extremely difficult until steam-powered ship in the 19C. Brazil's population never had to be mobilized en masse to fight in defense of the state.
  • A second overarching initial condition was that Brazil's soils and climates were ideal for sugar cultivation, and thus from the 16C onward it was one of the worlds major sugar producers. Sugar has a umber of features that predispose it to being grown on immense plantations with slave labor.
  • Brazil's political affairs changed abruptly in 1807 when Napoleon, in alliance with the king of Spain, invaded Portugal. Lisbon fell without resistance, and Prince Joao, fed Lisbon for Rio. Upon his arrangement Joao elevated Brazil from a colony to a kingdom and then declared that he would run what was left of the Portuguese Empire from Rio.
  • State ownership of the largest banks in China is no accident: it allows the government to reward its friends and generate employment, which is crucial to the survival of the regime. If the system were truly private the resulting shrinkage of credit would pose a huge political risk to a regime that buys political quiescence with factory jobs.
  • Banking crises are not a regular occurrence across time and countries, and therefore not a consequence of any general characteristics about banks
  • The extent of safety nets and prudential regulation are choices made by politicians, and in making those choices they are generally motivated by maximizing what is good for their own short-run futures, not what is desirable in the long-run.
  • The narrow libertarian conception of the ideal state has not role for the state in chartering or regulating banks. This view is founded on an incomplete conception of the state. The state needs banks as a financing tool. States without banks cannot and have never existed. Ironically, it is precisely the most basic function of the state recognized by libertarian theorists – defense – that makes banks so important. Any government that choose to forbear using banks as a tool to gain military and economic advantages would soon be replace by a stronger government that did.
  • The populist notion that the absence of constraints on majority rule results in more power and greater opportunities for the common man is based on a misunderstanding of the way democracies function. Democracies that least constrain the political power of majority rule tend to disadvantage the majority. It is a rare populist government that chooses policies that are conductive to both abundant credit and stability. Representatives can sell their votes in many ways and there is an active political market for deals that is often hard for voters to observe and even harder to control.
  • Societies do not choose their banking systems in any meaningful sense. They get the banking system that their political institutions and dominant coalitions allow.
  • The essence of the Hamiltonian formula for political entrepreneurship is finding the right time to seek support for measure that might not be sufficiently favored in normal times, hoping that the complexity of the legislative process will prevent reversal once normal times return. Political entrepreneurs that can shape popular opinions at critical moments can thus make a long-term difference.
  • True experts on finance are rare in the media: if you are a financial wizard, being a reporter tend not to pay as much as being a banker. Reporters in all countries – including the US – have political loyalties that bias their reporting.

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