This article appeared in National Review on April 18, 2014.
If you have time to read only one book about the causes of the 2008 financial collapse, read this one. You will discover that the banking crises that occur in some countries but not others are part of the “fragile design” of the banking system. They are not simply random occurrences, but come about as the product of political systems, part of a bargain among competing political interests.
Charles W. Calomiris and Stephen H. Haber, professors at Columbia and Stanford respectively, have written an exhaustively researched and readable volume. It compares banking systems in five countries and shows why some are more stable than others. (Full disclosure: Calomiris is a member of the Shadow Open Market Committee, a partner of the Manhattan Institute’s Economics21.org project, of which I am the director.)
Admittedly, the book is hefty. Although written by economists, it does not economize on words, or footnotes, or references. It is really six books in one — the banking histories of Britain, the United States, Canada, Mexico, and Brazil, and an analysis of how banks operate. But in order to understand how competing interests affect the stability of banks, it is vital to see how different structures evolved. And at less than six cents a page, the book is a bargain.
Few know, for example, that national chartered banks developed when governments wanted to raise money. The Bank of England, set up in 1694, was started by William of Orange and Parliament to pay for a government that wanted to spend more than it raised in taxes, because England was at war with France. In Brazil, in 1808, Dom João founded a monopoly bank, the Banco do Brasil, to issue inflationary paper money to repay his debts to the British. The Civil War, with its financing needs, substantially changed the U.S. banking system.
The actions of Treasury secretary Salmon Chase during the Civil War show that “incompetent treasury secretaries are not just a recent phenomenon,” in the words of the authors. Under Chase, the government started in 1862 to issue “greenbacks,” pieces of paper that had the status of currency, in order to bail out the banks. The government could pay for the war with paper rather than gold. We get a sense of déjà vu reading the following: “The problem facing Secretary Chase — the potential collapse of a group of major East Coast banks — could not be solved . . . without undertaking bold new steps. He had to create a mechanism to bail out the banks that he himself had sunk, and thus, constitutional or not, the greenback was declared legal tender.”
Chase changed his mind once he became chief justice of the Supreme Court. In 1869, in Hepburn v. Griswold, he voted against making paper money legal tender for private dollar-denominated contracts. President Ulysses Grant stacked the Court with two more justices to reverse the decision in 1871.
Chase’s problems during the Civil War are, unfortunately, a microcosm of U.S. banking history and not an aberration. Over the past 180 years, the United States has seen 14 banking crises, compared with two in Canada. More recently, since 1970 the U.S. has seen two banking crises, which puts it on a par with countries such as the Central African Republic, Chad, and Uruguay.
The fundamental problem is not just that governments are needed to charter banking systems, but that governments also fall prey to parochial interests that end up weakening that banking system. These interests vary by country. The authors call this “the Game of Bank Bargains.” The U.S. had to compromise with more interested parties than did Canada, and the compromises resulted in the stream of U.S. banking crises. Satisfying local interests also weakened banks in Mexico and Brazil.
Although Alexander Hamilton set up a system of a limited number of banks that received charters, this fell apart in the early 1800s, partly because these banks would not lend to farmers. So banks in the United States developed in the early 1800s as the product of an alliance between “unit banks” — banks with no branches — and agrarian populists.
Because unit banks have no branches to spread risk, they are inherently unstable. “In 1914,” write Calomiris and Haber, “there were 27,349 banks in the United States, 95 percent of which had no branches.” In comparison, in 2012, according to the Federal Deposit Insurance Corporation, there were 6,096 banks and 83,709 branches — an average of nearly 14 branches per bank.
The Glass-Steagall Act and other regulatory “reform” laws of the 1930s made bank consolidation and branch banking extremely difficult. In the 1970s, unrestricted intrastate branch banking was found in only twelve states, and no bank had branches over state lines. Interstate banking started in 1982, in response to the savings-and-loan crisis, when Congress allowed failed banks to be taken over by banks in other states. In 1994, Congress allowed both intrastate and interstate branching.
Branch banking gave more stability to the U.S. banking system. But the confluence of political interests that had caused banking crises in the past did not just disappear. Activists placed conditions on mergers that weakened the fabric of the system, so that fragility was, and still is, the name of the game.
One of the most fascinating parts of the book is the documentation of the grand bargains that were struck between activists and banks in the 1990s to allow the mergers that were legally permitted to go forward. Reasonable people might think that if banks were allowed to merge, then they would merge, if both banks consented. But it was not so simple. The 1977 Community Reinvestment Act encouraged banks to serve their local communities, and banks received grades of “outstanding,” “satisfactory,” “needs to improve,” and “noncompliance.” Activist groups such as ACORN, now disbanded owing to financial shenanigans, and the National Community Reinvestment Coalition used the law as a means of extorting banks to get additional subprime loans and funding in exchange for letting the merger proceed.
A guide published by the NCRC in 2007 stated: “Merger and acquisition activity presents significant opportunities for community groups to intervene in the approval process. . . . Even changing a rating from Outstanding to Satisfactory in one state or one part of the exam can motivate a bank to increase the number of loans, investments, and services to low- and moderate-income communities.” This meant that community organizers could hold up mergers by complaining that they did not do enough to help the poor. Since the poor often had lower credit ratings, banks processed loans of dubious quality to get higher CRA ratings.
For instance, write Calomiris and Haber, “agreements included a $760 million agreement from the Bank of New York to ACORN, an $8 billion agreement between Wachovia Bank and New Jersey Citizen Action, and a $70 billion commitment between the Bank of America and the California Reinvestment Coalition.” These were just three of 376 agreements between 1977 and 2007. By 2008, banks had $2.78 trillion in CRA commitments.
Banks also contributed directly to activist organizations. As of 2000, total payoffs came to $9.5 billion, according to the Senate Banking Committee findings cited in the book.
At the same time as activists were shaking down the banks, “no-docs mortgages,” in which the borrower does not have to verify income, became more common, and the down payment required to buy a home declined from a standard of 20 percent of the home’s purchase price to 3 percent. Government-sponsored enterprises Fannie Mae and Freddie Mac bought these loans, and they were repackaged and sold to unsuspecting investors.
In addition, regulators relaxed the amount of capital required to be held by banks. So when the crash came, banks that had invested heavily in loans of dubious quality did not have sufficient resources. It was a crisis ready to happen, and all it took was for interest rates to rise and real-estate values to fall.
Those on the left and on the right who warned of the crisis, including Fed chairman Alan Greenspan and activist Ralph Nader, were overruled or ignored. Politicians, including New York senator Charles Schumer, a Democrat, received substantial campaign contributions from Fannie and Freddie. As House speaker, Newt Gingrich defended them from regulation, and, after he left Congress, he received over $1.6 million in consulting fees from Freddie. Between 1998 and 2008, Fannie and Freddie spent $79 million and $95 million respectively on lobbying.
Calomiris and Haber write: “Neither the aggressive subsidization of mortgage risk that resulted from federal housing-finance policies and programs nor the costly failure of prudential regulation would have been tolerated by the political system if those two policy choices had not been made together, as part of America’s peculiar Game of Bank Bargains.”
In contrast, Canada has few banks, and these banks have nationwide branches, allowing them to spread the risk over many customers and cut administrative costs. Further, Canada regularly reviews its bank legislation and renews the charters to its banks. Until 1992, this took place every decade, and, since 1992, it has occurred every five years. This allows a periodic reevaluation that limits the power of special interests. Canada’s parliamentary system, similar to Britain’s, limits the power of states and political activists over economic policymaking, so the renewal process is not subject to the political forces that hold sway in the United States.
Fragile by Design shows that banking systems are not created in a vacuum. In order to avoid repeating past mistakes, we need to look at the fundamental reasons for U.S. banking crises. With great literary sensibility uncommon to economists, Calomiris and Haber have performed a public service by painstakingly identifying these root causes.
Diana Furchtgott-Roth, former chief economist of the U.S. Department of Labor, directs Economics21 at the Manhattan Institute. You can follow her on Twitter here.
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