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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 The Puzzle to be Explained Why is it so hard to create banking systems that are efficient and stable? This is especially puzzling because there is a causal relationship between finance and growth 1. 2. 3. 4. 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 2007;Correa 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). More puzzling still considering that: 1. Banking crises are not in the interest of politicians or bankers. 2. Banks are highly regulated and closely supervised. Nevertheless, crises are endemic The Frequency of Banking Crises, By Number of Countries, 1970-2006 60 Number of Countries 50 40 30 20 10 0 Number of Countries that had Zero Crises Number of Countries that had One Crisis Number of Countries that had Two or More Crises Source: Laeven and Valencia 2008; does not include former communist countries. Many countries are under-banked The Relationship Between Financial Depth (Private Credit/GDP) and GDP Per Capita Categories, 2008 225% 200% Ratio of Private Credit to GDP 175% 150% Mean=117% 125% 100% Mean=56% 75% Mean= 38% 50% 25% Mean=20% 0% Low Income Lower Middle Income Upper Middle Income Source: World Bank Financial Structure Database High Income And they tend to be the same countries Average Ratio of Private Credit/GDP by Frequency of Banking Crises, 197080% 70% Private Credit as % of GDP 60% 50% 40% 30% 20% 10% 0% Crisis Free Countries One Crisis Two or More Crises Source: Laeven and Valencia 2008 and World Bank Financial Structure Database Even more puzzling: Crisis prone countries have slower rates of credit growth Rates of Growth of Private Credit, by Number of Banking Crises, 1993-2006 Rate of Growth of Private Credit to GDP 60% 50% 40% 30% 20% 10% 0% Crisis Free Countries One Crisis Two or More Crises Source: Laeven and Valencia 2008; World Bank Financial Structure Database And causality is not running solely from crises to under-banking Mean Ratio of Credit to GDP, 1993 and 2006, by Number of Banking Crises, 1970 to 2006 90% 2006 80% Ratio of Private Credit to GDP 70% 60% 1993 50% 2006 40% 1993 1993 30% 2006 20% 10% 0% Zero Crises One Crisis More than One Crisis Source: Calculated from Laeven and Valencia 2008, and World Bank Financial Structure Database. 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. How do we resolve these paradoxes? In order for there to be a banking system, three property rights problems have to be mitigated: 1. 2. 3. 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. Solving these property rights problems requires institutions 1. 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). 2. 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). 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. 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. 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. Even worse, the parties that control the government have multiple margins for opportunism. They can: 1. 2. 3. 4. Expropriate banks outright. Monetize debt by printing money. Borrow from the banks and then renege on the loans. 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. 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. Nor can economic actors rely on cross monitoring 1. The incentives of bank insiders, minority shareholders, depositors, debtors, and taxpayers are not aligned. 2. This means that parties in control of the government can exploit those differences in incentives for their own ends. The Implication: It’s 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. 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 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 government’s incentives are aligned through loans and corruption. Everyone else is a source of rent. 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. In order to study these coalitions and the deals they generate, we… look 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 A stable deal under autocracy: Porfirian Mexico, 1876-1911 1. 2. 3. 4. 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. Mexico’s Banking System Grew The Mexican Banking Industry, 1897-1913 35 Number of Banks 30 25 Assets as % GDP 20 15 10 Deposits as % Assets 5 - 97 18 98 18 99 18 00 19 01 19 02 19 19 03 04 19 05 19 19 06 07 19 19 08 Source: Anurio de Estadística Fiscal, 1912-13. 09 19 10 19 11 19 12 19 19 13 With a concentrated competitive structure Structure of the Mexican Banking Industry 90% 80% BLM Banamex 70% Market Shares 60% 50% 40% 30% 20% 10% 0% 1896 1899 1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 Bank Shareholders Earned Rents Ratio of Market to Book Values (weighted average), Mexican Banks 2.50 2.00 1.50 1.00 0.50 0.00 1901 1902 1903 1904 1905 1906 1907 Source: Maurer and Haber 2007. 1908 1909 1910 1911 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. Limits on bank entry created barriers to entry in downstream industries Four Firm Ratios in Textile Manufacturing 40% 35% 30% 25% 20% 15% Mexico 10% Mexico Expected Brazil 5% USA India 0% 1888 1891 1893 1895 1900 1904 1909 1912 1913 When Porfirian political institutions fell apart, the banks were expropriated Ratio of Bank Assets to GDP, Mexico, 1897-1929 35% 30% 25% 20% 15% 10% 5% Haber, Razo, and Maurer 2003. 29 28 19 27 19 26 19 25 19 24 19 23 19 22 19 21 19 20 19 19 19 18 19 17 19 16 19 15 19 14 19 13 19 12 19 11 19 10 19 09 19 08 19 07 19 06 19 05 19 04 19 03 19 02 19 01 19 00 19 99 19 98 18 18 18 97 0% The subsequent regime could not generate a coalition-so most credit had to come from state-owned banks Bank Credit in Mexico, as Percent of GDP, 1940-1978 18% Developmen t Banks 16% 14% 12% 10% Other Private Banks 8% 6% 4% Commercial Banks 2% Source: Del Angel 2002 78 19 76 19 74 19 72 19 70 19 68 19 66 19 64 19 62 19 60 19 58 19 56 19 54 19 52 19 50 19 48 19 46 19 44 19 42 19 19 40 0% When deficits grew, the government expropriated the banks Deposits, Private Credit, and Reserve Ratios, Mexico, 1948-1982 60% Reserve Ratio 50% 40% Deposits/GDP 30% 20% Private Credit/GD 10% 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967 1966 1965 1964 1963 1962 1961 1960 1959 1958 1957 1956 1955 1954 1953 1952 1951 1950 1949 1948 0% When the banks were re-privatized the coalition that was formed produced a banking crisis Bank Claims on Private Sector, as Percent of GDP 40% 35% 30% 25% 20% 15% 10% 5% 0% 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 PRI leaders, bank insiders, and depositors jointly expropriated minority shareholders and taxpayers Non-Performing Loans, as Percent Total Lending 60% 50% 40% 30% 20% 10% 0% 1991 1992 Declared NPL 1993 Rediscounts 1994 Renewed and Restructured 1995 FOBAPROA 1996 The initial coalition in the U.S. was between federalists, bank insiders, and minority shareholders 1. 2. 3. 4. 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 government’s 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. This coalition was not stable given America’s political institutions 1. 2. 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: A. The need to finance public works B. Political demands to expand access to banking services 3. State governments responded to these counterincentives: A. Political demands could be channeled through suffrage and party competition B. Suffrage expanded because of competition between states An example: Pennsylvania’s 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 state’s 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. But…reform meant creating monopolies in each district! And they had to share rents with the state government! The basic history of US banking 1. 2. 3. 4. Demands by debtors create smaller and smaller monopolies through unit banking. Unit bankers form a coalition with debtors and parties in control of the government to block a more competitive structure. In short, the system of segmented monopolies not broken down until the 1990s! But even then, politics intervenes. It is possible to get a coalition of bank insiders, minority shareholders, and debtors expropriating depositors and taxpayers. Conclusions and Implications: No banking systems outside of politics 1. There are systematic differences in banking systems between authoritarian and democratic governments. 2. But parliamentary democracy, in and of itself, does not necessarily produce efficient credit markets. 3. Banking is a fragile plant.