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Fragile by Design: Book Review

Fragile by Design: The Political Origins of Banking Crises & Scarce Credit (2014), Calomiris & Haber. The key point of this book is the relationship of banking to the political/institutional framework of countries.Governments create banking systems for their own needs, such as financing wars. Banking systems are susceptible to collapse when banks have high risks and inadequate capital. Then governments have to determine to what extent the banking system will be propped up. The U.S. system is designed to be high-risk and financial crises have happened often. The Canadian banking system is robust and has not had any banking crisis since the 1830's. Why? Other case studies identify very different banking structures, usually established for various political purposes, some of which work reasonably well, some don't.

This is a long academic book written by economists with the usual financial jargon that will annoy most non-economists. However, the content is useful and worth the effort. The authors describe the history of banking, beginning with early Medieval attempts. Considerable time is spent on the British system, one established for pragmatic reasons (mainly to finance perpetual wars) and evolving into a modern if imperfect banking system. Central to the British model was the Bank of England, the first British bank that was chartered (and given special rights). The Bank of England evolved into a central bank, which figured out how to handle financial collapses (mainly by flooding the market with money). Britain spent massive amounts of money on war, funded mainly by debt through a sophisticated banking system. Financial collapses happened with regularity, partly because of high risks associated with massive leverage. Another important issue was attempting to maintain the gold standard (with the British pound essentially priced too high for the manufacturing/economic base of England).

The most coverage is spent on the American system, why it is fragile and suffers from recurring collapses--and government bailouts in various forms. Hamilton set up a national system based on the British experience, establishing the First Bank of the United States which essentially functioned as a central bank including multiple branches across states. This was a practical solution and under Hamilton as Secretary of the Treasury weathered the Panic of 1792 effectively. The Constitution was silent on banking and states charted banks, usually for improved state funding and liquidity. The First Bank was dismantled by the Jeffersonians (first, federal monies were withdrawn, then the bank was not rechartered). Bank chartering was relegated to the states, essentially dozens of experiments with local banking. Banks did not cross state lines and most states used unit banking (only a single location was allowed). The result was thousands of banks, many under-capitalized and unable to diversify; therefore, very unstable. The degree of regulation and examination, capital and liquidity requirement varied by states, including what were considered "wild cat banks." Until the Civil War, banks issued their own paper money. Major panics and depressions happened every 20 or so years, plus minor panics in between--wide-spread paper money and land speculation resulted in instability. Banks, especially rural banks, failed by the thousands. The creation of national banks (done to finance the Union's military) resulted in the Treasury issuing paper money and better capitalized banks (required to hold Treasuries). Unit banking and speculation in railroads led to continued panics, however.

The Federal Reserve was established in 1914, but unit banking remained. [Note that the Fed was not always the most competent regulator, mainly based on politics and different perspectives on what central banks should be concerned about.] Fed set up to hold excess reserves when loan demand was low; source of additional reserves when needed; ability to expand the money supply. At the most extreme of the Great Depression, the entire banking system essentially collapsed and FDR declared a bank holiday on day one of his administration. New Deal legislation created a relatively stable system; the Glass-Steagall Act separated commercial from investment banks and established the Federal Deposit Insurance Corporation (FDIC). Major changes included more urban country (less populist focus on unit banks), ATMs and other technology, inflation from 1960s and shadow banks (e.g., commercial paper), bank consolidation.

The Community Reinvestment Act of 1977 encourage banks to serve local communities (redlining was a problem). Not much effect until 1990s, in part to pressure megabanks to comply (plus Clinton & Bush push). They made loans they normally would not have made, especially mortgages, which kept increasing until 2007.

Deregulation of S&Ls led to financial collapse of that industry and a federal bailout. S&Ls until 1990s were a major mechanism to subsidize mortgages. Most shut down after FIRREA of 1989; this episode required a major federal bailout.

Interstate banking became federal Law in 1994 with the passage of Interstate Banking & Branching (Riegle-Neal) Act. Big bank mergers happened quickly after that. Mega-banks were created, made even bigger by allowing commercial & investment banks to merge. Benefits included scale efficiency and risk diversification (plus too big to fail).

Interest rates were too low, there was too much liquidity worldwide, a free-market ideology, too much risk-taking, and capital was too low. Fannie & Freddie were required to meet targets of low income loans and underserved area loans, weakening their underwriting standards. Fannie privatized in 1968, split--GNMA for FHA & VA mort.; whole structure camouflaged subsidized housing, incentives lead to excessive risks (at public expense). GSE act of 1992 required GSEs to hold 30% of loans in low-moderate income borrowers (they lowered credit requirements), less capital, plus manipulation, then 21st century, even more sub-prime loans. 21st century: Greenspan complained of no market discipline. [Note: $1.6 million consulting fee for Gingrich from Freddie Mac; GSEs massive lobbying; top recipients included Schumer, Obama, Dodd, Frank. Over $1 trillion in high risk mortgages by 2006 (with Alt-A $4.8 trillion by 2008)]. GSE Act of 1992 required on 2 1/2% equity against assets; securitization, only 1.6% ("skin in the game").

Policy makers & regulators made things worse. Rating agencies requirements resulted in AAA ratings for bad MBSs & CDOs, minly underestimting risk (incentivized to do it). Some regulators thought ratings too conservative. Monetary policy was loose 2002-5 (with real Fed funds rate negative). Overall lower pricing of risks. Delayed action by regulators once mortgage losses became obvious, about 2006 (cognitive capture, interest group pressure?). Some banks took enormous risks (Lehman, Bear, AIG, Fannie), some did not (JP Morgan, Goldman, Credit Suisse); high franchise value banks were more conservative--more effective risk management.

Subprime crisis outcome of bad political bargains: CRA, banks allowed to become enormous, emphasis on lending to poor people, poor incentives structures on Fannie, Freddie, and others. Problems to solve: 1) banks management of risks, 2) reform government risk management policies, and 3) end too big to fail free riding. Dodd-Frank not very effective. Volcker Rule on proprietary trading not important. Authors conclude that not much help will come from politicians and regulators to prevent next crisis.

Chapter 10 is on the Canadian banking system. Since 1840 Canada had no major financial crises, while the US had 12, with little government intervention and no central bank until 1935;Canada has a staples-based economy reliant on exports. Canada is mainly composed of a few very large banks with nationwide banking (authority over banks was centralized from the beginning), which allows scale economies and diversification. Banks are rechartered regularly (every five years since 1992, every 10 years before that), limiting monopoly profits. Note that branching is useful for big business moving goods to ports (some in the US) and then globally.

Canada's banking system, beginning in 1817 with the unchartered Bank of Montreal; chartering came in 1822 and modeled on Hamilton's First Bank of the United States (nationally chartered for 20 years with branch banking, but limits on paper money, loan levels and annual report requirements). Other big banks followed, including the Quebec Bank and Bank of Canada. British North American Act of 1867 established the constitution and was the basis for creating the Dominion of Canada nation which eventually included seven provinces. Banking began as an alliance with merchants, financiers and political elites, vs.less powerful populists (e.g., farmers). Small unchartered banks appeared across the provinces. Farm populations favored unit banks, but large national banks more stable. In 1890 there were 38 chartered banks, down to 8 by 1966. Chartered banks failed but were taken over (process led by Bank of Montreal).

Canadian banks were resilient during the Great Depression and no banks failed. However, the Bank of Canada was established in 1935 as a central bank with a monopoly over paper money. Post-World War II, "near banks" held a large share of financial assets (36% in 1967). Changes in the Back Act gave banks more flexibility and expand financial coverage (e.g., insurance and mortgage companies), as well as acquire "near banks." Canadian banks avoided the 2008 US mortgage crisis. Conservative banking based largely on regulatory oversight (including rechartering of banks).

Chapter 10 on Mexico, a long-term autocratic political and banking environment. No banking system exists without a stable government and autocratic governments can expropriate the existing banking system. Mexico went through periods of instability, followed by authoritarian rule based on specific partnerships. Mexican revolt and independence became a rule of various warlords (1821-1876); Santa Ana was probably the most successful and became president on several occasions. Relative peace arrived with General Porfirio Dias who ruled as an autocrat from 1877-1911, with a coalition that included a banking system that provided funds to the government and Diaz-friendly groups. Corruption was built into the system. Banamex became a superbank (central bank). The vast majority of people were excluded, which led to rebellion and Dias' ouster in 1911. Once again war lords ruled with rebellions, civil war, and assassinations. The banking system disintegrated. The war lords created their own political party, the Nation Revolutionary Party (PNR) in 1929, which empowered the war lords, political bosses, government workers and labor leaders. They monopolized government until the late 1990s. A complex banking system was created to promote the needs of the PRI and their coalition, but minuscule. A complex financial system developed, including development banks to channel credit, government protection (taxpayers bore most of the risk). Chapter 11 covers the risks and failures of this system, called a "fragile bargain." Accounting rules inflated bank asset values.

Chapters 12-13 on Brazil: "inflation machines."

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