Banking Crises Yesterday and Today

Sep 29, 2009

Financial crises appear to be a common and fairly constant feature of the economic cycle. Banking crises, a distinct subset of financial crises, consist either of panics, moments of temporary confusion about the unobservable incidence across the financial system of observable aggregate shocks, or severe waves of bank failures which result in aggregate negative net worth of failed banks in excess of one percent of GDP. Unlike financial crises, however, historical evidence suggests that banking crises cannot be seen as an inevitable result of human nature or the liquidity transforming structure of bank balance sheets, and adverse macroeconomic circumstances alone are not sufficient to produce banking crises.

A survey of the history of banking crises traces unusual bank fragility to risk-inviting microeconomic rules of the banking game established by governments. Some risk-inviting rules took the form of visible subsidies for risk-taking, as in the historical state-level deposit insurance systems in the U.S., Argentina's government guarantees for mortgages in the 1880s, Australia's government subsidization of real estate development prior to 1893, the Bank of England's unlimited discounting of paper at low interest rates prior to 1858, and the expansion of government-sponsored deposit insurance and other bank safety net programs throughout the world in the past three decades, including the generous government subsidization of subprime mortgage risk-taking in the U.S. leading up to the recent crisis. Other risk-inviting rules historically have involved government-imposed structural constraints on banks, which include entry restrictions like unit banking laws that constrain competition, prevent diversification of risk, and limit the ability to deal with shocks. Another destabilizing rule of the banking game is the absence of a properly structured central bank to act as a lender of last resort to reduce liquidity risk without spurring moral hazard.

Further, history teaches us that regulatory policy often responds to banking crises, but not always wisely. A favorable outcome in Britain in the 19th century, for example, resulted from a political consensus in favor of reform that created strong political incentives to get reform right, in order to stop the boom and bust cycles that had plagued the economy for decades. Counterproductive responses to crises include the decision in the U.S. not to retain its early central banks, which reflected misunderstandings about the Second Bank of the United States' contributions to financial instability in 1819 and 1825, and the adoption of deposit insurance in 1933, which reflected the political capture of regulatory reform. A consistent theme of the historical record is that the ability of regulatory reform to improve the financial system depends crucially on the political environment.

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