Two centuries of commercial banking: crises, bailouts, mergers and regulation

Romesh Vaitilingam interviews Richard Grossman for Vox

July 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5337]

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with economic historian Professor Richard Grossman from Wesleyan University. Richard and I met in London in April 2010 when he spoke about his new book "Unsettled Account: The Evolution of Banking in the Industrialized World since 1800".

Richard Grossman: The idea is to look at banking structure over the last 200 years and to look at sort of four types of events that have shaped banking system. So I looked at financial crisis, topical at the moment, bailouts, also topical, merger movements and government regulation; actually, all four of those. How wonderful. All of those are topical and what I try and do is looked comparatively across Western Europe, the United States, Canada and Japan, what we would think as the advanced industrialized, OECD type countries that were among the first to develop commercial banking and to look at that and to look at some of the commonalities.

It is very hard. Again, it is a little humbling because I will admit to you that I don't read Finnish or Japanese for that matter and then probably one or two other languages of countries that I cover. But the problem I find with a lot of what's missing from a lot of comparative studies of banking I find is that they are written, they are usually a conference volume and you have one person writing on Britain, one person writing on France and one person writing on Japan. And you put this all together and if you are lucky, they'll be a well read editor who will sit down and who will do some comparative piece at the beginning or the end.

But I was a little bit--what I think is needed is someone to actually, even though they are not necessarily experts of this different countries or conversant with the material or the languages that the laws and histories are written in, to do an in depth comparative study. And so to say, “How were financial crisis generated across different countries and how do bailouts differ over time. What were responsible for merger movements?” And so the idea is to take a truly comparative look across these countries over the last 200 years and to try and get some sense as to what are the main forces that are responsible for banking evolution.

Romesh: So perhaps you can take one of these topics and focus on the financial crisis you say is very topical, perhaps you can give us a picture of the differences and how different banking systems, different national banking systems have coped with crisis.

Richard: Sure. Well, in terms of how crisis are generated. I sort of divide crisis into three, I think of three key things that have generated crisis. The one by far the largest is what I call in book “Boom Bust”, which I think would be relevant for what's been going on for the last few years. And this is the sort of thing that was described by Irving Fisher, 70 or so years ago, by Hyman Minsky and Charles Kindleberger. And the notion is that you have an economic expansion that gets a little bit out of control. There's an expansion of credit. There may be a creation of new banks but the banks that are there start making more and more loans and as the expansion grows, banks continue to make loans even beyond the point where these loans make economic sense.

And as Fisher writes about it in his book, he says, "If only the process would stop at equilibrium." But of course it doesn't and the boom continues. This usually includes speculation in one or more types of securities or assets and at some point, there is an overreaching and it all collapses. And the collapse leads to a collapse of the banks and it leads to a collapse of the people who owe banks money which leads to a further collapse and a knock on effect.

The financial crises have been remarkably consistent over time and they have affected different countries. I would say that most of these have been quite similar in the sense that you see a great commonality across all countries. Countries with very different financial systems, very different economic systems and you still see this boom-bust situation.

There are other factors, structural factors. One of the reasons why during the Great Depression, Britain I would say was relatively stable, was the fact that Britain was composed of a few large banks, which has benefits in terms of especially when the economy turns down. If you only have a dozen or so very large banks, it is easier for them to protect themselves there. They are larger. They are able to cooperate with each other. They are better able to defend themselves.

So one of the things that looking cross-country has shown is that countries with more extensively branched banks--larger banks, more concentrated banks, these things all seem to go together--that those countries were generally more successful at avoiding banking crisis.

In terms of dealing with them there have been different styles. I sort of have classified. I have classifications for everything. I have classifications of how countries rescue banking systems. One would be the bailout and that is we would have a financial concern that is in trouble and the government lends it money or goes and somehow and provides assistance.

This is a very old type of bailout; the bank of New South Wales did it back in the 1820's in Australia. In Germany, there was the Stadt Hausen Bank and these were subjects of bailouts and these are targeted at one particularly important firm that the government or other financial firms considers to be essential. And this is the too-big-to-fail argument.
Now, in general, economists are worried about bailouts because bailouts can lead to moral hazard. If I know I am going to be bailed out then I am going to take a completely different approach to my risk profile, it will be different than if I know that I am completely on my own.

The second sort of form of rescue, this is pioneered by the British, and that is what was known as the lender of last resort operations. And that is the case where the firm or bank maybe in perfect good shape. They just don't have cash to pay out. The notion being that it may be that the bank is in fine shape but there is no market for its collateral so if I’ve made loans against certain securities, and there’s no markets for those securities, I can't sell them for a moment so I as a bank will be liquidity strapped and so what I could do is if there is a lender of last resort like the bank of England, then I just go to the lender of last resort. And I give them my securities and then they lend me money against them or I sell them the securities.

Forrest Capie who is at the bank of England now and City University has a wonderful phrase. He talks about the lender of last resort as a frosted glass window that's raised a couple of inches above the desk and you come to the central bank and you push your securities under the glass. And they give you money bank and they don't care who it is which is completely like a buyout. They don't care who you are, they just discount good collateral.

So that would be the second type and again, this was pioneered in Britain and has been developed over the years but really the British was the first to do it. And Walter Bagehot certainly made it famous in his 1873 book "Lombard Street".

The third is something what I call more extreme measures and this is when the government nationalizes banks, takes over the banks and declares a banking holiday or has somehow more extensive intervention. And again it is not so much that one country did one thing and one country did another thing. But it is that different circumstances have brought out different things. But over time I would say lender of last resort became popular.

During the Great Depression, more extensive, more emergency measures came into play because it was more severe that anything that had happened before and I would argue anything that had happened since. So these more extreme measures--the Italians nationalized the banks, the Americans declared bank holidays so that banks couldn't go out of business because they were closed. And so you couldn't withdraw money from your bank because your bank was closed or you couldn't take bank to court for not paying deposits. So in other countries in Scandinavia declared deposit moratoria saying that you couldn't take out deposits and government-issued guarantee. So these are extensive measures. Again, the more severe the crisis, it seems to be these are the measures that seem to come up more and more. And in the current crisis, not to divert us to what is going on now. I would say that those have become more likely outcomes.

Romesh: Let us talk a little bit about lessons for the current crisis. One of the big issues being discussed at the moment in debate about the future of banking, regulation is about this distinction between universal banking sand separating to into narrow banks and “casino” banks, for want of a better term. What kind of light does your comparison history have to shed on that discussion?

Richard: It is a very interesting question. Well, there's the difference between universal banks and separated commercial and investment banks and then there is also sort of the unregulated banks. One the difficulties in writing this book was that you think of commercial banks as banks. But as it turns out of course, you have savings banks and other kinds of mortgage…building societies and different. Every country has many different varieties of financial institutions and so there is the issue between of the regulated and the unregulated. And the unregulated would be what's popularly known as the shadow banking system, and hedge funds, and many insurance companies.

I have come to the conclusion that having a lot of unregulated financial activity is maybe not such a good idea. It's a tricky business, though, because the market moves very rapidly. This is little bit of a problem I have with the Basel Acccords and that is the market moves very rapidly. A lot of the Basel Accords allows banks to use the internal ratings-based approach…I can't remember the acronym, but in terms of rating capital, in terms of rating assets and what sort of capital it has to be.

I think the market moves very rapidly, and I think that the market is much more nimble that either regulators have been or ratings agencies have been. It's extraordinarily difficult to do that and I don't know the answer as to how that should be done, but I think, clearly, we need more regulation and more ways of thinking about how to achieve that sort of sufficient regulation without over-regulating.

After the Great Depression, there was such a total financial meltdown that countries around the world instituted what I call in the book a financial lockdown. Interest rates were regulated. Banks were regulated in terms of what they could do. In the United States, for example, we had Glass Steagall. The Belgians, at this point, also got rid of universal banking, or they separated commercial and investment banking. There was some nationalization. There were a lot of different things that were done to restrict banks in terms of what they could do.

That lasted from the end of World War II until the late '60s, early '70s. This was the breakdown of Bretton Woods. There were interest rate pressures. When market rates go up, it's hard to have capped deposit rates and lending rates. And so, all this sort of broke down. But the thing about this period of lockdown is there were no financial crisis. Banking didn't evolve very much but there were no financial crisis between 1945 and 1972, really. There were none.

And then you had Bank Haus der Stadt in Germany, and you had Franklin National in the US, and it sort of went on from there. And so, the downside of having all that super regulation, that very tight regulation, is that the banking industry or banking didn't evolve very much for 20 or 25 years. That's the downside.

The upside is we had a very stable banking environment. I guess the example that I would use is that you could reduce fatalities on the M1 to practically zero on the motorway if you just reduced the speed limit to 20. I think that's what the situation was with banking. We reduced the speed limit to 20, and we had no fatalities, but we didn't really have much throughput on the M1.

Striking this balance is just so difficult. I don't claim to have the answers. I'm getting a sense when we've gone too far, but I think it's very hard for anybody to say exactly where we need to be. But I think that's the issue of striking the balance between our desire for safe and sound banking as it states in Basel on safety and stability, versus… Again, I don't agree with people who say that finance somehow doesn't contribute. Finance contributes a lot to the development of the economy, and financial innovation is very important. It allows people to use funds that they might not have.

I don't mean to say that we should ban all financial innovation, but we somehow have to strike a balance between financial innovation and maintaining safety and soundness. That's what I think is the crucial issue.

Romesh: You're looking over a very long period of time, over 200 years, across a range of different countries. Has there, over time, generally been a kind of convergence in the form of banking systems, or do national banking systems still seem very distinct and different?

Richard: There has been a fair bit of convergence, I would say, and the outlier here being the United States where we have many, many, many more banks per person than pretty much any other industrialized country. That's got to do with our very strange and wonderful system of regulation and states. What you see if you look from the beginnings of industrialization through the Great Depression--so the Great Depression is a great dividing line—but if you look from, say, 1800 onwards, what you see is the birth of commercial banking; rapid growth. If you just look at a graph of the number of banks in a country, you see this wavelike pattern. A huge increase, and then you reach a point and where that point is, that magical point where it maxes out is hard to say, but at that point you can either have a financial crisis, or you can have the development of a merger movement, or you can have the development of a financial crisis that is followed quickly by a merger movement, as banks get taken out.

But there's something that leads to a turnaround, and what you see in almost all of these countries is a rapid increase and then a gradual--I'm describing it in terms of a smooth line, but the line is never smooth--but then there's a greater concentration.

So you do see a real convergence. There's a greater amount of concentration. Even in the United States the number of banks is falling, but it's clear if you look at this wave. I'm waving with my hand which, of course, doesn't do your listeners any good. You just see this rapid increase and then this gradual decline over time. That's quite similar.

Then you hit the Great Depression and everything stops. Everything is pretty much frozen in time from then until after World War II. Things stay pretty much static until the late '60s, early '70s when, again, there's inflation, the breakdown of Bretton Woods, the breakdown of domestic limits on interest rates.

And then things really start to happen, and that's where we get into this newest round of deregulation. Politicians think the way to get around these things is to deregulate it. In some sense, I think, probably, it was right. I think, probably, having interest rates that are more flexible sort of makes more sense than having tight limits on interest rates.
Because, having the interest rate on your savings account limited to 2.5% when you can go and buy commercial paper that's paying a percent more just punishes individual savers. Again I don't want to come across as someone who's opposed to deregulation, but on the other hand, it's got to be done well. It's got to be done with appropriate safeguards. And of course that's the devil in the details.

Romesh: Final question. Originally is there, looking across all the countries in Europe, looking across all the periods of time, is there a star performer amongst them? Is there a banking system that, in a sense, has combined not being too susceptible to financial crisis, and at the same time being reasonably innovative in its banking system?

Richard: There's so many peculiarities and so many differences. There are some that have been relatively crisis free. Canada has not had much in the way of banking crises. Canada, in a sense like Britain, was dominated by a few large banks. People have made the comparison between Canada and the United States for a long time. Canada is a country that's much smaller, but has a dozen or two dozen banks, whereas the United States has many thousands of banks. Of course, there was a Canadian Banker's Association that did a great deal of self regulation. So Canada has been a little bit less crisis prone, certainly than the United States. The United States really stands out next to anyone. I have to say, we have perfected having banking crises in the United States. It does have a lot to do with having had a lot of small banks, but I would argue that's not really our main problem, but that is certainly one of the issues.

Britain has been on the banking system; after the Baring crisis in 1890, Britain was really quite stable through the Great Depression. Britain didn't have a banking crisis during the Great Depression. Some of this had to do with the fact that concentration had been quite advanced in Britain.

If you look at a graph of British banking concentration it goes way up, and by the time you get to World War I, there are a dozen banks. Britain is much bigger than Canada; bigger in terms of population, so it's a much more populous country; really a small number of banks. High banking concentration, and you could argue that the banks are able to act very defensively, perhaps even like a cartel.

And so, Britain becomes quite stable, British banking, and it remained so during the Great Depression. There's no banking crisis in Britain during the Great Depression. There's also no banking crisis in Canada.

Again, this issue of how much concentration is good. This gets me to talking about another part of the book about mergers, but again the issue of how much concentration, how concentrated you want your banking system to be.

If you were designing one from scratch, you would probably want it to be more concentrated than that in the United States where we have too many. I would argue you might not want it quite as concentrated as a place like Canada. You do lose something in terms of dynamism, I think, in the development of banking.

But again, we're back on this point of where do you want to draw the line? Where do you want to strike the balance between a dynamic financial system and a stable financial system? I don't want to say that you want to have dynamism or boring, but there is this question of how expansionary and contractionary you want your banking system to be, and I think the judgment of that one is still up in the air.

Romesh: Richard Grossman, thank you very much.

Richard: Thank you.