Fragile Banks, Durable Bargains: Why Banking is All About Politics and Always Has Been

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Fragile Banks, Durable Bargains Why Banking is
All About Politics and Always Has Been

• Charles Calomiris
• and
• Stephen Haber
• Presented at World Bank Financial Structures
  Conference
• June 16, 2011

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The Puzzle to be Explained

• Why is it so hard to create banking systems that
  are efficient and stable?

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This is especially puzzling because there is a
causal relationship between finance and growth

• Evidence from economic history (Gerschenkron
  1962 Cameron 1967 Sylla 1975, 2006, 2008 North
  and Weingast 1989 Neal 1990 de Vries and van
  der Woude 1997 Rousseau and Wachtel 1998
  Rousseau 2003 Rousseau and Sylla, 2003, 2004).
• Evidence from cross-country regressions (King and
  Levine 1993 Levine and Zervos 1998 Beck et. al,
  2000).
• Evidence from cross-regional studies (Jayaratne
  and Strahan 1996 Black and Strahan 2002 Guiso,
  Sapienza, and Zingales 2004, Cetorelli and
  Strahan 2006 Dehejia and Lleras-Muney
  2007Correa 2008).
• Studies of finance dependent industries (Rajan
  and Zingales 1998 Wurgler 2000 Cetorelli and
  Gamberra 2001 Fisman and Love 2004 Beck,
  Demirguç-Kunt, Laeven, and Levine 2007).

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More puzzling still considering that

• Banking crises are not in the interest of
  politicians or bankers.
• Banks are highly regulated and closely
  supervised.

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Nevertheless, crises are endemic
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Many countries are under-banked
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And they tend to be the same countries
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Even more puzzling Crisis prone countries have
slower rates of credit growth
9
And causality is not running solely from crises
to under-banking
10
A very troubling implication

• Many under-banked economies repeatedly supply
  credit imprudently
• After a crisis is resolved, banks appear to once
  again misallocate scarce credit.

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How do we resolve these paradoxes?

• In order for there to be a banking system, three
  property rights problems have to be mitigated
• Bank insiders, minority shareholders, and
  depositors must be protected from expropriation
  by the government.
• Depositors and minority shareholders must be
  protected from expropriation by bank insiders.
• Bank insiders, depositors and minority
  shareholders must be protected from expropriation
  by debtors.

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Solving these property rights problems requires
institutions

• To solve problem of government expropriation,
  institutions must be created that limit the
  authority of government (veto points in
  legislatures), or that compensate bankers for the
  risk of expropriation (limits on competition to
  raise rates of return).
• To solve problem of expropriation of depositors
  and minority shareholders, institutions must be
  created that punish fraud and tunneling
  (prudential regulation)-- or that compensate
  depositors and minority shareholders for the risk
  that they will be expropriated (limited
  liability, deposit insurance, and limits on
  competition).
• 3. To solve problem of expropriation by
  debtors, institutions must be created that allow
  bankers to damage debtors reputational capital
  (credit reporting), repossess physical collateral
  (property registers, commercial and bankruptcy
  law, courts and police)--or compensate bankers
  for the possibility that they will be
  expropriated (limits on competition to raise
  rates of return, limited liability).

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Virtually all of these institutions involve the
government, which

• Allocates bank charters
• Supervises and regulates the banks.
• Enforces bank accounting standards.
• Enforces debt contracts.
• Runs the deposit insurance system.

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This creates a dilemma

• Any government strong enough to regulate banks,
  protect against fraud and tunneling, and
  adjudicate contracts is also strong enough to
  expropriate the banks.

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Worse, the government is not a disinterested party

• The parties that control the government may have
  their own financial interests.
• The parties that control the government
  simultaneously borrow from the banks and regulate
  them.
• The parties that control the government
  simultaneously enforce debt contracts and may
  need the political support of debtors.
• The parties that control the government
  simultaneously liquidate failed banks and
  allocated the losses--but they may need the
  political support of depositors.

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Even worse, the parties that control the
government have multiple margins for opportunism.
They can

1. Expropriate banks outright.
2. Monetize debt by printing money.
3. Borrow from the banks and then renege on the
   loans.
4. Raise reserve requirements and force the banks to
   hold those reserves in government bonds that
   yield negative interest rates.
5. Force banks to direct loans to government
   enterprises.
6. Force banks to direct loans to politically
   crucial constituencies.
7. Force banks to forgive or reschedule debts.
8. Insure depositors beyond statutory limits.
9. Show regulatory forebearance towards bank
   insiders.
10. Rescue or bailout bank insiders, minority
    shareholders, depositors, and debtors at the
    expense of taxpayers.

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Worse still, economic actors cannot easily
monitor every margin

• Both the intent of reforms and their actual
  economic consequences can be difficult to
  determine ex ante.
• This is especially the case if the government is
  simultaneously reforming multiple institutions,
  some of which potentially enhance the value of
  property rights and some of which reduce them.

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Nor can economic actors rely on cross monitoring

• The incentives of bank insiders, minority
  shareholders, depositors, debtors, and taxpayers
  are not aligned.
• This means that parties in control of the
  government can exploit those differences in
  incentives for their own ends.

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The Implication Its the politics, stupid

• The property rights institutions that underpins
  banking systems are the product of political
  deals.
• These deals are about the creation and
  distribution of economic rents and the
  maintenance of political power.
• The deals determine which laws are passed, which
  judges are appointed, who bears the risk in the
  event of loss, and which groups of people have
  which licenses to contract with whom, for what,
  and on what terms.

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All deals are not created equal

• Some political coalitions will generate deals
  that produce a financial crisis.
• Some political coalitions will produce a stable
  banking system, but credit will be allocated
  narrowly and growth will be constrained.
• Some political coalitions will produce a stable
  banking system, in which credit will be allocated
  efficiently

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The basic autocratic deal

• A coalition can be formed between the parties in
  control of the government and bank insiders to
  create rents by limiting entry, compensating the
  insiders for the risk of expropriation through
  super-normal returns.
• Minority shareholders are compensated for the
  double-risk of expropriation by super-normal
  returns.
• The governments incentives are aligned through
  loans and corruption.
• Everyone else is a source of rent.

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Democracy changes the calculus, but it is not a
panacea

• Debtors can vote, making it harder to block entry
  in the long run.
• The authority and discretion of the parties in
  control of the government are more limited,
  meaning that insiders and minority shareholders
  face lower expropriation risk.
• But, mass politics creates a special problem
  unless the owners of capital can exert influence
  beyond their numbers, they are going to be
  subjected to expropriation by debtors.
• Their best move may be to pass the burden of
  expropriation on to taxpayers.

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In order to study these coalitions and the deals
they generate, welook at what actually happened

• Our approach is to study the history of politics,
  bank regulation, the structure of the banking
  industry, and its performance over long time
  spans for six cases
• Scotland, England, USA, Canada, Mexico, Brazil

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A stable deal under autocracy Porfirian Mexico,
1876-1911

• The political system an autocracy that needed
  to create a banking system for its own political
  survival.
• The deal
• A. Regulated entry and segmented
  monopolies.
• B. Special privileges for two banks.
• C. Credit for the federal and state
  governments.
• D. Rent sharing with politicians.
• E. Tunneling and fraud mitigated by
  interlocking
• directorates and high capital
  ratios.
• The coalition political elites, bank insiders,
  and minority shareholders.
• The outcome A stable banking system, a source of
  public finance, but credit distributed very
  narrowly.

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Mexicos Banking System Grew
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With a concentrated competitive structure
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Bank Shareholders Earned Rents
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And mostly lent to themselves

• Percent of non-government loans made to banks
  own boards of directors
• Banamex 1886 to 1901
  100
• Mercantil de Veracruz 1898-1906 86
• Coahuila, 1908
  72
• Durango, 1908
  51
• Mercantil de Monterrey, 1908 31
• Nuevo León, 1908
  29
• Source Maurer and Haber 2007.

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Limits on bank entry created barriers to entry in
downstream industries
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When Porfirian political institutions fell apart,
the banks were expropriated
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The subsequent regime could not generate a
coalition--so most credit had to come from
state-owned banks
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When deficits grew, the government expropriated
the banks
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When the banks were re-privatized the coalition
that was formed produced a banking crisis
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PRI leaders, bank insiders, and depositors
jointly expropriated minority shareholders and
taxpayers
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The initial coalition in the U.S. was between
federalists, bank insiders, and minority
shareholders

• At the state level, bank insiders received
  charters and shared rents with state
  governments--who in turn granted few charters.
• These banks did not lend to all comers.
• The Bank of the United States was the
  governments bank, the largest commercial bank,
  and the only bank allowed to branch across state
  lines.
• In short, the U.S. banking system was made up of
  segmented monopolies.

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This coalition was not stable given Americas
political institutions

• State-chartered bankers pressured their
  Congressional delegations to not renew the
  charters of the Banks of the United States.
• State governments also had counter-incentives
• The need to finance public works
• Political demands to expand access to banking
  services
• State governments responded to these
  counter-incentives
• Political demands could be channeled through
  suffrage and party competition
• Suffrage expanded because of competition between
  states

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An example Pennsylvanias Omnibus Banking Act

• Until 1814, Pennsylvania had only 4 banks, all
  located in Philadelphia and owned by
  Federalists--who only lent to Federalists.
• The 1814 act (passed over the objections of the
  states governor) ended the oligopoly, dividing
  the state into 27 banking districts, and
  allocated at least one bank to each district. In
  all, it chartered 42 new banks.
• Butreform meant creating monopolies in each
  district! And they had to share rents with the
  state government!

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The basic history of US banking

1. Demands by debtors create smaller and smaller
   monopolies through unit banking.
2. Unit bankers form a coalition with debtors and
   parties in control of the government to block a
   more competitive structure.
3. In short, the system of segmented monopolies not
   broken down until the 1990s!
4. But even then, politics intervenes. It is
   possible to get a coalition of bank insiders,
   minority shareholders, and debtors expropriating
   depositors and taxpayers.

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Conclusions and ImplicationsNo banking systems
outside of politics

• There are systematic differences in banking
  systems between authoritarian and democratic
  governments.
• But parliamentary democracy, in and of itself,
  does not necessarily produce efficient credit
  markets.
• Banking is a fragile plant.