Politics & Policy

Behind the Game of Bank Bargains

Everything you wanted to know about banking but were afraid to ask

‘Everyone knows that life isn’t fair, that ‘politics matters,’” Charles W. Calomiris and Stephen H. Haber write in their new book, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (from which we ran an adaptation here). “We recognize that politics is everywhere,” they continue, “but somehow we believe that banking crises are apolitical, the result of unforeseen and extraordinary circumstances, like earthquakes and hailstorms.” That’s simply not true, Calomiris and Haber argue: “The politics we see operating everywhere else around us also determines whether societies suffer repeated banking crises . . . or never suffer banking crises.” Fragile by Design will make you skeptical of the “version of events told time and again by central bankers and treasury officials,” and critical when that version is “repeated by business journalists and television talking heads.” The authors talk with National Review Online’s Kathryn Jean Lopez about the book, banking, morality and politics, Canada, fatherhood, and even Game of Thrones.


Kathryn Jean Lopez: Is the “Game of Bank Bargains” anything like Game of Thrones? Why do you set things up this way?

Haber: Well, there are a lot fewer beheadings in the Game of Bank Bargains than in Game of Thrones, and none of the protagonists in our book are 15-year-old monarchs with antisocial personality disorder. More seriously, the point of explaining bank regulation as a game in Fragile by Design is to get across the idea that laws and rules are not produced by robots programmed to maximize social welfare. They are the outcome of strategic actions of interested parties — a game, as it were — and those strategic interactions can produce unlikely alliances that work against the interests of society as a whole.

#ad#Let’s take the United States in the 1990s as an example. There was a strategic alliance that consisted of banks that were in the process of merging and activist groups. The activists supported bank-merger applications, and in exchange the banks directed hundreds of billions of dollars in mortgage credit through the activist groups. In order to make this alliance stable, the megabanks and the activists had to draw the housing GSEs [government-sponsored enterprises], Fannie Mae and Freddie Mac, into the partnership. Fannie and Freddie agreed to purchase the loans that the megabanks had made to satisfy their activist allies, and in return received the right to back their portfolios with paper-thin levels of capital. Each of the three players in this game had a strategic objective — to further its own interests. The one group that did not have a seat at the table as the game was being played was taxpayers, who were presented with the bill when the game was over.


Lopez: Is there a danger you downplay morality in banking?

Calomiris: Policy in banking, as in all things, should be morally defensible. As James Madison recognized, however, moral achievements of government are largely the consequence of the quality of rules that govern a society, not the inherent virtues of its citizens. Laws, he reminded us, are not fashioned for angels, but rather to govern the affairs of flawed human beings. Most important perhaps, good laws and regulations predictably occur more in societies whose rules of political engagement make it harder for groups of citizens to use the government as a means of taking advantage of other citizens.


Lopez: Do taxpayers have any control over this, a real role to play in banking and financial reform beyond praying the money is real?

Haber: They absolutely do! The laws that govern the banking system are passed by our elected representatives. Obviously, the average taxpayer is not going to become an expert on the arcane details of bank regulation. But taxpayers can apply a simple heuristic: There are no free lunches. When a government official promises a subsidy, taxpayers should ask, who is ultimately going to bear the cost of that subsidy? When a government official promises a subsidy and implies that no one is going to bear the cost, taxpayers should grab hold of their wallets.

Taxpayers might keep the following example in mind: Americans were told that the mortgage giants Fannie Mae and Freddie Mac should receive a range of special privileges that subsidized their operations, because those subsidies were passed on in the form of reduced costs of homeownership. Everyone was getting a free lunch. This turned out to be false on two counts. First, a large body of research has shown that the majority of the subsidy was captured by Fannie and Freddie’s stockholders and managers, not homeowners. Second, when Fannie and Freddie failed in 2008, they had to be bailed out at enormous taxpayer expense. Housing subsidies turned out to be a very expensive lunch.


Lopez: Is Canada better at banking than we are?

Calomiris: In Fragile by Design, we show that banking instability and credit scarcity are not inevitable outcomes dictated by the nature of banks, per se, but rather are outcomes of a political bargaining process. It’s not that Canadian bankers are more innovative or brighter than American bankers. The political rules of the game, defined by Canada’s constitution, and under which Canadian banks operate, are and always have been much more conducive to stability, competitiveness, and efficiency. It is not just that Canada’s banks have operated nationwide branching banks (after all, our recent crisis illustrates that nationwide branching banks can be very unstable, too). The key difference throughout the past two centuries has been that, in the United States, government banking policies have been designed to reward the particular political alliance that controls banking regulation. The nature of that alliance has changed over time, but the common feature has been the ability of particular groups to use the democratic political process to seize control of the U.S. banking system to pursue their self-interest at the expense of the broader society. In Canada, in contrast, the design of the constitution limited the ability of special interests to control government banking policies, which has allowed those policies to be designed to promote efficiency and stability.


#ad#Lopez: How much does the future of American prosperity and security have to do with banking?

Haber: Banking has everything to do with the future of American prosperity and security. When small businesses want to expand, they borrow from the banking system. If they cannot do so, the cost is felt in slower rates of new small-business formation, and hence slower job growth. When families want to purchase a home, they borrow from the banking system. If they cannot do so, they forgo the opportunity to build equity in a house, as well as forgo the security that comes with homeownership. When young people want to invest in their own human capital through higher education, they borrow from the banking system. If they cannot do so, they are sidelined in an economy that increasingly demands high levels of skill and preparation. A banking system that either provides too little credit, such as that of Mexico or Brazil, or that provides credit in a volatile fashion, lurching from crisis to crisis, such as that of the United States, is not consistent with the creation of a robust economy that allows for social mobility.


Lopez: If it were the fall of 2008 again, how might politicians act differently? Should they?

Calomiris: If policymakers had been willing to recognize problems as they became increasingly clear in 2007 and 2008, then they would have been able to react faster, and could have averted the severe systemic collapse in the fall of 2008, and the types of bailouts that ultimately were relied upon. But that would have required recognizing how bad the regulatory policies had been in the decade leading up to the crisis, which was something no one in authority wanted to do. Instead, for one and a half years, policymakers kept pretending that the crisis was merely a “liquidity” problem rather than a deep “insolvency” problem. That made the crisis much worse.

The first signs of looming insolvency risks were in the spring of 2007, and the signs became clearer in August 2007, January 2008, and March 2008, when the Fed bailed out Bear Stearns. In fairness to regulators, the extent of subprime-related losses was hard to estimate at first, and loss projections grew over time as it became increasingly apparent that the scale of risky mortgage lending was greater than had been believed. But the purpose of maintaining sufficient levels of bank equity is precisely to deal with such unforeseen circumstances. Amazingly, the Fed and the Treasury still did virtually nothing between March 2008 and September 2008 to counter the continuing decline in bank equity ratios (in market value) by forcing banks to shore up their financial positions by issuing stock (to raise their equity ratios). The markets were open and equity issues were possible, but policymakers at the Fed, the Treasury, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission did not use their authority to force banks and other financial institutions at risk to raise equity capital. Because of the steady and visible deterioration of so many large financial institutions from 2006 to September 2008, when Lehman failed, it was a match in a tinderbox.

In September 2008, in the wake of the Lehman failure, it still would have been possible for the Treasury to initiate a program of preferred stock assistance (like that of the Reconstruction Finance Corporation in 1933, in which government assistance took the form of loans that encouraged recapitalization of weak banks), which would have avoided taxpayer stock ownership in distressed banks. But instead, the secretary of the Treasury pursued a flawed vision of a program of assistance based on the purchase of distressed bank assets, which never made sense and which never transpired. This wasted months of additional precious time. By the time the government had found the political will to do something meaningful, and was willing to recognize the depth of the problem, the months of wasted time had made the amount of assistance needed even greater, hence the need for government recapitalization of financial institutions like Citigroup.


Lopez: How can the media cover financial reform better?

Haber: It is not reasonable to expect that journalists are going to become experts in the arcane details of banking regulations and the features of complex financial derivatives. But journalists can keep a simple heuristic in mind: Banking crises are not the product of random, difficult-to-predict events, like hailstorms and mountain-lion attacks. They occur when banking systems are vulnerable by construction. Two conditions have to be met in combination: There must be sufficient risk in the loans and other investments the banks are making, and there must be inadequate capital on bank balance sheets to absorb the losses associated with those risky loans and investments. If a bank makes only solid loans to solid borrowers, there is little chance that its loan portfolio will all of a sudden become non-performing. If a bank makes riskier loans to less solid borrowers, but sets aside extra shareholder capital to cover the possibility that those loans will not be repaid, its shareholders will suffer a loss — but it will not become insolvent. These basic facts about banking crises are not a secret to bankers or government regulators; they are as old as black thread.

The implication is that journalists should always be asking three questions about the banking system: Are bank balance sheets becoming stuffed full of risky assets? Are regulators failing to increase capital requirements sufficiently in response to the increase in asset risk? And what are the implications for the public if the answer to both questions is yes? Needless to say, they should not simply rely upon the statements of bankers and regulators in seeking the answers.


#ad#Lopez: You’re both fathers of daughters; what’s your realistic hope for their economic lives?

Calomiris: I think that the important parts of my daughters’ ability to realize their dreams will depend primarily on their own persistence, imagination, and integrity, and knowing them as I do, I don’t worry much about their ability to make their dreams come true. I do recognize, however, that they will face some strong headwinds from the looming economic problems that everyone in their generation must face — most obviously, the unsustainable debt burdens of entitlement programs, and also the continuing pandemic of global financial instability. But I am an optimist about the next generation. Paradoxically, I believe that it is precisely because they will have to confront some very harsh realities — which the prior generation irresponsibly ignored — that they will do so well.

History gives us cause for such optimism. If we look at the rise of Margaret Thatcher in Britain, we see an example of what happens when people in a democracy are forced to confront their predecessors’ economic-policy errors. Britain’s low growth and high inflation became intolerable. Thatcher’s reforms ending high inflation and restoring economic growth were welcomed by a citizenry that had previously supported nationalization of industry and extremely high tax rates. Democracies don’t always get it right, and they can be very slow to respond, but when confronted by the high costs of major policy errors, they are capable of responding quite effectively.


Lopez: What’s the future of banking in America?

Haber: I am extremely doubtful that Dodd-Frank is going to make the American banking system more stable. In fact, by institutionalizing too-big-to-fail protection, I fear that it will encourage bankers in “Systemically Important Financial Institutions” to take even bigger risks. This is what economists call moral hazard: If I know that there is a mechanism in place to bail me out, I am more likely to make wild bets; if the bets pay off, I win big; if the bets fail, you cover my wager.

I also worry about the incentives that politicians have to address issues of income inequality through the banking system, rather than through the fiscal system. Taxation and spending policies to effect redistribution tend to be politically difficult because they appear on the government’s budget, where taxpayers can see them. Incentivizing banks to lend to targeted groups for redistributive purposes is politically easier, because they do not appear in the government’s budget. The problem is that bankers are not sheep to be fleeced; they tend only to agree to targeted lending programs if there are government guarantees backing those loans, or if they can extract some other valuable concession, such as the right to back those loans with low levels of prudential capital. Those guarantees and concessions mean that, ultimately, taxpayers are on the hook — but they do not realize it until the bill comes due in the form of a bank bailout.

— Kathryn Jean Lopez is editor-at-large of National Review Online.


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