1. 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

2. The Puzzle to be Explained Why is it so hard to create banking systems that are efficient and stable?

3. This is especially puzzling because there is a causal relationship between finance and growth 1.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). 2.Evidence from cross-country regressions (King and Levine 1993; Levine and Zervos 1998; Beck et. al, 2000). 3.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). 4.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).

4. 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.

5. Nevertheless, crises are endemic

6. Many countries are under-banked

7. And they tend to be the same countries

8. Even more puzzling: Crisis prone countries have slower rates of credit growth

9. And causality is not running solely from crises to under-banking

10. 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.

11. How do we resolve these paradoxes? In order for there to be a banking system, three property rights problems have to be mitigated: 1.Bank insiders, minority shareholders, and depositors must be protected from expropriation by the government. 2.Depositors and minority shareholders must be protected from expropriation by bank insiders. 3.Bank insiders, depositors and minority shareholders must be protected from expropriation by debtors.

12. 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).

13. 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.

14. 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.

15. Worse, the governmen t 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.

16. Even worse, the parties that control the government have multiple margins for opportunism. They can: 1.Expropriate banks outright. 2.Monetize debt by printing money. 3.Borrow from the banks and then renege on the loans. 4.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.

17. 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.

18. 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.

19. 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.

20. 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

21. 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.

22. 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.

23. 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

24. A stable deal under autocracy: Porfirian Mexico, 1876-1911 1.The political system: an autocracy that needed to create a banking system for its own political survival. 2.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. 3.The coalition: political elites, bank insiders, and minority shareholders. 4.The outcome: A stable banking system, a source of public finance, but credit distributed very narrowly.

25. Mexico’s Banking System Grew

26. With a concentrated competitive structure

27. Bank Shareholders Earned Rents

28. 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.

29. Limits on bank entry created barriers to entry in downstream industries

30. When Porfirian political institutions fell apart, the banks were expropriated

31. The subsequent regime could not generate a coalition-- so most credit had to come from state-owned banks

32. When deficits grew, the government expropriated the banks

33. When the banks were re-privatized the coalition that was formed produced a banking crisis

34. PRI leaders, bank insiders, and depositors jointly expropriated minority shareholders and taxpayers

35. The initial coalition in the U.S. was between federalists, bank insiders, and minority shareholders 1.At the state level, bank insiders received charters and shared rents with state governments--who in turn granted few charters. 2.These banks did not lend to all comers. 3.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. 4.In short, the U.S. banking system was made up of segmented monopolies.

36. This coalition was not stable given America’s political institutions 1.State-chartered bankers pressured their Congressional delegations to not renew the charters of the Banks of the United States. 2.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 counter- incentives: A.Political demands could be channeled through suffrage and party competition B.Suffrage expanded because of competition between states

37. 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!

38. The basic history of US banking 1.Demands by debtors create smaller and smaller monopolies through unit banking. 2.Unit bankers form a coalition with debtors and parties in control of the government to block a more competitive structure. 3.In short, the system of segmented monopolies not broken down until the 1990s! 4.But even then, politics intervenes. It is possible to get a coalition of bank insiders, minority shareholders, and debtors expropriating depositors and taxpayers.

39. 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.