Economics

Why US banks fail and Canadian banks don’t.

Review of Fragile By Design: The Political Origins Of Banking Crises and Scare Credit by Charles Calomiris and Steven Haber.

In this book Calomiris and Haber try to answer a very simple question: Why do US banks fail much more often than Canadian Banks?  In the last 180 years, there were 14 major banking crises in the US and only two very minor crises in Canada.  There have been zero banking disasters in Canada since the early 19th century.  Yes, occasionally individual banks in Canada do fail, but there have been no major banking crises in Canada since 1832.

Banks, say the authors of this book, are a mirror of the political system they live in.  Some kinds of societies have banking systems that avoid crises  and some don’t.  The worst countries for banking crises are Argentina, the Democratic Republic of Congo and the US.  Many, many countries have bad banking systems and only a very few have good systems.  Why is this, the book asks?

The reason banks fail is really not complicated.  Banks tend to collapse when they expose themselves to high risk and when they have inadequate capital on their balance sheets to buffer loses.  All bankers know this say Calomiris and Haber.

Good banks not only fail rarely but they also offer adequate credit to a wide range of deserving businesses.  Bad banks not only fail, but they often practice what is called under-banking.  Under-banking means offering inadequate credit to the society they exist in.

Canada has many good banks.  Banks in Canada are extremely stable; they just don’t have crises like the ones the US seems to have every 10 or 15 0r 20 years.  And Canada offers very adequate credit,  Canada’s credit to GDP ratio is 95%.  In comparison, Mexico is under-banked, it has a 19%  credit to GDP ratio.  The social costs of under banking are obvious.  Canada has very high GDP growth and Mexico very low growth.

The sad part of this story is that there are very few countries with both abundant credit and no banking crises.  Only 6 out of 117 countries have both abundant credit and no banking crises.

The authors of this book feel that some of the problems of bad banking have to do with the fact that now-a-days the costs of bank failure are not borne by the bankers, bank shareholders or depositors.  They say that after the 1950s  the costs of bank failure shifted to the taxpayers.  They present quite a bit of evidence that when bankers have to pay for their own loses there are many fewer crises because bankers who know that won’t be bailed out take fewer risks and hold much more capital.  When banks have to pay for their own losses, there are very few of the famous Banks Too Big To Fail.

The authors ask, Why do governments look the other way when banks take high risks and at the same time deny credit to businesses and consumers who are excellent credit risks? Why are banking systems that provide both large amounts of credit and stability so rare? Their answer is that fragile banks with scare credit reflect the fundamental political institutions of the countries they are part of.  One main symptom they see is that democracies that limit populist coalitions, also limit the kinds of conflict of interest in banking that leads to major banking crises.   They say that Democracies with lots of populist coalitions also tend to have very fragile banking systems.

Calomiris and Haber find three conflicts of interest which are worsened by populism and which end up causing fragile banks. 1) Governments that simultaneously regulate Banks and also look to them as a source of finance for themselves tend to fail.  2) Governments that discipline debtors on the  behalf of banks, but rely on these same debtors for political support are looking for trouble.  3) Governments that allocate bank looses among creditors after banking failures but rely on depositors (the largest group of banking creditors) for political support also tend to have severe problems.

The authors say that the rules of banking are not made to maximise  social welfare.  They are made by a political game that delivers wealth and power to a certain group of people.  They call this game The Game of Bank Bargins.   The players in this game are those people with a stake in the particular banking system.  This group controls the government, the bankers and everyone involved in this particular banking system.  The rules are set by the nations political institutions and these rules determine who gets to play and who gets left out.

The benefits of banking don’t only go to the bankers.  Politicians also get their share.  The group in control of the government definitely gets a share of banking profits.  Whichever coalition that forges the strongest partnership with the government splits the rest of the profits after the bankers get their share.

The rest of the book consists of the details of how all of this works and how it plays out in practice.

The authors of this book belong to the Heritage Foundation, which is a very conservative, Republican group.  And I’m a pretty staunch Democrat and liberal.   And I do see a lot of problems with government but in general it seems to me that the Democratic idea that government is more helpful than harmful is correct. However, even as a liberal,  I have to say that this book makes quite a lot of sense to me.  Even Paul Krugman has mentioned many times that if US banks resembled the good old conservative, boring Canadian banks, the US would be in a far better place than it finds itself in right now.

Book information

Fragile By Design: The Political Origins Of Banking Crises and Scare Credit
Calomiris, Charles and Haber, Steven
Princeton University Press, Princeton and Oxford
Copyright, 2014
Kindle Edition

 

 

11117-mcdonald-lake-sunset-linomaster-6500-pss
McDonald Lake in Glacier National Park, Montana.  Picture by Hanselmann Photography. 

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