Fragile by Design: The Political origin of banking Crises and Scarce Credit by Charles Calomiris and Stephen Haber

Politicians here and elsewhere have made their name by attacking bankers' greed, other countries’ mistakes, globalisation, deregulation, central bankers' blindness, too loose monetary policy, you name it-except usually themselves. There is no denying that these issues matter and contributed to inflaming the 2008 crisis. All sorts of new ideas on how to make the system safer are constantly being suggested and many being implemented- increasing capital requirements; (forlorn) attempts to restrain bankers’ bonuses ;ring-fencing retail and investment banking; abolishing proprietary dealing (the Volker rule); increasing competition; or setting up proper resolution regimes for ' too big to fail' banks .

 
But are they appropriate?  What this excellent book shows is the importance of learning from other countries .We fret here about not having enough banking competition and yet Canada, which managed to sail through without an impact has a hugely concentrated banking system. We worry about universal banks and yet the book demonstrates how the abolition in 1999 of the Glass-Steagall Act which after the Great Depression in the US separated commercial and investment banking in fact provided an extra cushion to the banks when the crisis hit in 2008 allowing the easy absorption of failing investment banks by commercial banks. Loose money made things worse but wasn’t the cause of the crisis itself. And interestingly regulation of investment banks had been tightened before the crisis. There was plenty of regulation. The problem was that it was simply ineffectual.

There are three generally accepted theories on what might lead to a crisis. One is that a given banking structure might allow liquidity mismatches to develop and dangerously increase liquidity risk exposure. Another focuses on the inter-linkages- as each bank deals with its own balance sheet without taking into account the wider impact of its actions (externalities) on the system as a whole - in other words it fails to price any likely  ‘systemic’ risk. And the third is about human nature-people are myopic, acting with excessive optimism or excessive fear, with potentially disastrous consequences.

 All three exist across the globe and are real threats.  And yet banking crises have been absent in many countries despite these problems being evident. So it must be something else. And that something else, they conclude, is politics.

 Nowhere is that more obvious than in the US where the two academic authors teach . The subprime lending that was at the root of the financial crisis that engulfed us all was in fact the result of a coalition over the previous couple of decades of banks, urban active groups and influential politicians who achieved acceptance of a deal that brought about a dramatic decline in the underwriting standards of Fannie Mae and Freddie Mac, the two institutions mostly engaged in mortgage finance. The institutions had agreed to subsidise mortgages for the urban poor in exchange for larger government safety net subsidies in the form of low capital requirements. And the regulators were as the authors say, 'asleep at the wheel' while expansionary monetary policy encouraged citizens to take more risks with their borrowing.
 
The credit risk agencies to whom regulation was outsourced assumed that house prices, based on crises over the previous ten years, would never fall! Mortgage backed securities into which mortgages were turned and then sold in the secondary markets were perceived as risk free and they also required a lot less capital set against them. The market for Credit Default Swaps, basically insurance purchased by the originators of sub prime mortgage backed securities boomed on the assumption that the risk was low. The 'systemic' impact when borrowers could no longer meet repayments was huge.

Regulators could have intervened and raised capital ratios but they didn’t. And yet central bankers like the Fed and the Bank of England who failed to perceive the dangers are if anything getting even more powers thrust on them. Will a next crisis be averted? Perhaps if our regulators read this book."

Vicky Pryce's updated 'Greekonomics', is out in paperback (Biteback)