Pundits, policymakers, and macroeconomists often remind us that banking crises are nothing new, an observation sometimes used to argue that crises are inherent to the business cycle or perhaps human nature itself. Charles Kindleberger (1973) and Hyman Minsky (1975) were prominent and powerful advocates of this view, where banking crises result from the propensities of market participants for irrational reactions and myopic foresight. The point has been stressed more recently by Carmen Reinhart (2008) in her Vox column “Eight hundred years of financial folly."
This column, based on Calomiris (2009a, b), covers the historical lessons for today’s crisis.
When and why do banking crises occur?
Banking crises consist of:
- Panics, moments of temporary confusion about the unobservable incidence across the financial system of observable aggregate shocks; or
- Severe waves of bank failures that result in aggregate negative net worth of failed banks in excess of 1% of GDP.
Banking crises are a distinct subset within the broader set of phenomena known as financial crises. These include asset-price bubbles, exchange-rate collapses, and a host of other phenomena. Financial crises are a common and fairly constant feature of the economic cycle, as Bordo et al (2001) show. Is the same true of banking crises?
Four basic facts about banking crises provide a starting point for understanding their origins and show the importance of distinguishing banking crises from other financial crises.
- First, banking crises tend to occur around cyclical downturns. They are closely associated with prior rises in the liabilities of failed businesses and declines in asset prices. Not surprisingly, waves of bank failures are clearly traceable to large declines in the values of bank loans, which reflect declines in the fortunes of borrowers.
- Second, banking crises were relatively rare historically, despite the lack of modern government policy interventions designed to stabilise the banking system.
- Third, bank panics can happen without a significant increase in failed banks (the Panic of 1907, for example); while at other times, many bank failures occur without any systemic banking panic (as during the wave of US agricultural bank failures in the 1920s). This suggests that somewhat different phenomena underlie the panics and waves of failures.
- Fourth, perhaps most interestingly, banking crises vary in their frequency across countries and across time, and the differences in the propensities for crises are dramatic. The US banking system experienced an unusually high propensity for both panics and waves of bank failures historically.
Crisis risk and the rules of the game
What accounts for the variation across time and across countries in the frequency and severity of panics and waves of bank failures? A survey of the history of banking crises traces unusual bank fragility to risk-inviting microeconomic rules of the banking game established by governments.
Some risk-inviting rules took the form of visible subsidies for risk-taking, as in the historical state-level deposit insurance systems in the US that failed disastrously in the 1920s, Argentina’s government guarantees for risky mortgages in the 1880s, Italy’s pre-1893 guarantees for the liabilities of the Banca di Roma, which financed the Roman real estate boom of that period, and Australia’s government subsidisation of real estate development prior to 1893.
In the US in the 1830s and the 1920s, states that had enacted systems of bank liability insurance in which neither entry nor risk-taking were effectively constrained experienced far worse banking system failure rates and insolvency severity of failed banks than did other states (Calomiris 1989, 1990, 1992).
One of the most interesting examples of risk-inviting policy was the Bank of England’s unlimited discounting of paper at low interest rates prior to 1858, which drove the boom and bust cycle in Britain that caused banking panics roughly every decade from 1819 to 1866.
Recent research that investigates the determinants of banking fragility across different countries in the current era reaches a similar conclusion. The expansion of government-sponsored deposit insurance and other bank safety net programs throughout the world in the past three decades accounts very well for the increasing frequency and severity of banking crises in the current era (see, for example, Caprio and Klingebiel 1996, Demirguc-Kunt and Detragiache 2000, Barth, Caprio, and Levine 2006, Demirguc-Kunt, Kane, and Laeven 2009).
Lessons for today
As discussed in detail in Calomiris (2009a), the subprime crisis, like the episodes of historical banking crises described above, was not just a bad accident.
On an ex ante basis, subprime default risk was excessive and substantially underestimated during the 2003-2007 period. Reasonable, forward-looking estimates of risk were ignored, and compensation for asset managers created incentives to undertake underestimated risks. Those risk-taking errors reflected a policy environment that strongly encouraged financial managers to underestimate risk in the subprime mortgage market. The policies were specifically designed to encourage risk-taking in the mortgage market. Several are especially deserving of emphasis here (see Calomiris 2008 and Calomiris 2009a for more detailed analysis). Numerous housing policies promoted subprime risk-taking by financial institutions by subsidising the inexpensive use of leveraged finance in housing. Those policies included:
- Political pressures from Congress on the government-sponsored enterprises Fannie Mae and Freddie Mac to promote ‘‘affordable housing’’ by investing in high-risk subprime mortgages
- Lending subsidies for housing finance via the Federal Home Loan Bank System to its member institutions
- Federal Housing Administration (FHA) subsidisation of extremely high mortgage leverage and risk
- Government mortgage foreclosure mitigation protocols that were developed in the late 1990s and early 2000s to reduce the costs to borrowers of failing to meet debt service requirements on mortgages, which further promoted risky mortgages, and 2006 legislation enacted to encourage ratings agencies to relax standards for subprime securitisations
All these policies encouraged the underestimation of subprime risk, but the behaviour of members of Congress toward Fannie Mae and Freddie Mac, in the name of affordable housing, was arguably the single most destructive influence leading up to the crisis.
Public resentment over the abuse of special privileges by mortgage monopolists, Fannie Mae and Freddie Mac, who fuelled the subprime bubble, and whose internal emails (Calomiris 2008) show that they did so largely to preserve the special privileges conferred upon them by the government, is reminiscent of the discussion of the moral hazard produced by the Bank of England.
The liquidity risk that arose from the heavy dependence on repo financing by US investment banks in recent years parallels the growth of the discount brokers in London who built up huge liquidity risk in the banking system, which was the primary means of inflating bubbles during the first half of the 19th century in Britain. Just as the debate over financial regulation today grapples with the question of whether to impose prudential regulations on non-banks, Britain struggled with the problem of an ineffectual, narrow approach to defining prudential regulation, which was limited to the Bank Act of 1844’s reserve requirement against Bank of England note issues and did nothing to limit deposit growth or bill discounting by brokers.
The concern about the “Greenspan put” and the moral-hazard consequences of the “too-big-to-fail” doctrine in the wake of the rescue of Bear Stearns, AIG, Citibank, and other large financial institutions is reminiscent of the Bank of England’s struggle to cancel its put option in the London market for bills and rein in other institutions’ entitlements to unlimited accommodation during crises, a practice that was ended in 1858, and proven in 1866.
Calomiris’ brief survey of the history of banking crises traces bank fragility to risk-inviting microeconomic rules of the banking game established by governments, the most important of which are the rules that subsidise risk. Other destabilising rules include limits on bank entry and the failure to establish a proper lender of last resort.
The subprime crisis exemplifies the historical pattern all too well. Government subsidisation of risky mortgages in the US accelerated markedly in the years prior to the crisis. That, along with prudential regulatory failures to prevent excessive risk-taking, allowed the mortgage risk binge of 2003-2007 to produce a worldwide financial collapse.
As the US gears up to respond to the subprime crisis with regulatory reforms, history suggests important lessons. Regulatory policy often has responded to banking crises, but not always wisely. A favourable outcome in Britain in the 19th century, for example, resulted from a political consensus in favour of reform that created strong political incentives to get reform right, in order to stop the boom-and-bust cycles that had plagued the economy for decades. But counterproductive responses to crises are also a possibility, either due to misunderstanding about the sources of crises or political capture of regulatory reform.
A consistent theme of the historical record is that the ability to improve regulation in reaction to banking crises depends crucially on the political environment.
Barth, James, Gerard Caprio, Jr., and Ross Levine (2006), Rethinking Bank Regulation: Till Angels Govern, Cambridge University Press.
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