Banking Panics Through Historical Economics

from the Atlanta Fed

Since 1840, 12 different financial crises have plagued the United States. Our neighbor up above, Canada, has been crisis-free during that same period, despite having a banking sector that constitutes a larger part of its economy and a more volatile exports-based economy.

At a recent Public Affairs Forum, Charles Calomiris of the Graduate School of Business at Columbia University opened with these statements and then tried to explain this enigma using historical economics.

You have to think historically to think usefully. Traditional economic models don’t incorporate historical analysis, despite its usefulness in explaining factors behind crises or finding holes.

Leafing through history reveals a number of reasons the two North American countries have had such different financial experiences, according to Calomiris. First, unlike the Canadian branch-based system, the U.S. system has always been unit based, which is prone to risk after a crisis hits. The National Monetary Commission identified this risk factor after the Panic of 1907, finding unit banks to be central in creating liquidity risk and causing panics. Second, government safety nets, like deposit insurance, have led both banks and bank customers to be overconfident. Recent research shows that the spread of deposit insurance since 1970 has been a net contributor to financial instability globally.

So why did the United States choose a unit banking system, if it’s so risky and inefficient? Why implement regulatory policies that have made the financial system vulnerable at times? Calomiris says the answers lie in the political institutions and special interests that developed and gained influence in our country over history. The political structure of the United States led to the creation of unit banks, while Canada’s constitution prevented these types of banks.

They were impervious to dominant political coalitions. But American landowning farmers preferred unit banks because they tied the availability of credit to the local economy. Despite finding the risks early on, regulators were unable to overcome unit banking advocates and change the industrial organization of the economy.

In a global and more recent context, Calomiris says the spread of poorly constructed government safety nets and inadequate prudential regulation are the main issues that policymakers must tackle today.

These outcomes are a reflection of country-specific politics, not general and unavoidable characteristics of banks.