Warning Fragile: Banking System Inside

Small is beautiful

Should we analyse the reason of why financial systems are unstable by looking at the problem from a political dimension? Yes, or at least we should keep that perspective in mind.

I am currently reading a book, “Fragile by design: The Political Origins of Bank Crisis and Scarce Credit” from C. Calomiris and S. Haber which makes precisely these arguments.

Their research follows the study of types of financials systems globally and they noticed that similarly complex financial systems are not necessarily unstable. The reason for this lies in the political organisation of that country (eg: USA Vs Canada) which has different incentives when regulating finance.

A few years back, I made a similar observation in a paper called “The 2007 Meltdown: A Legal Phenomenon”, even though I didn’t make it a general rule. I argued that the political desire of the Bush administration to increase home ownership within the ethnic minorities in the country (by amending the Community Re-Investment Act) pushed a decrease in underwriting standards for mortgages. Other laws followed that allowed banks to sell-off those mortgages and the impact was that credit supplied increased at the cost of financial stability.

An analogy for this is to see the financial system as a car on a highway. The faster it goes (the more credit being supplied) the more likely you are to have an accident (suffer a financial crisis). It is the government’s role to set the speed limit but doing so requires taking into consideration pressure from the car manufacturer (banks) and the passengers (borrowers) who want the car to quickly reach home. As governments are partly funded (via taxes) and elected by both the car manufacturer and their passenger, they have to engage in a risky exercise where they should find the optimal speed limit, in the USA they failed at finding it.

What needs to be taken from this observation is that the financial system in which we live is a reflection of the industry, but also of the public demand from customers and end users. Governments need to make a fine-tuning exercise which is complicated by the dependence it has on this industry which brings revenue and its electorate which gives their vote.

A way out would go towards a financial system with smaller banks that due to their size have less influence over government and regulators ‎, but also a smaller customer base so that the political result of favourising one bank would be negligible.