Banks on the Brink is a systematic investigation into why some countries have proven more prone to bank failures and financial instability than others. Mark Copelovitch and David A. Singer focus on how international economic forces combine with the political decisions that shape the structure of financial markets. They examine capital inflows and the relative prominence of securities markets versus banks to explain how and why banks behave badly, taking on excessive risks. The authors find that it is the combination of capital inflows and well-developed securities markets that creates instability. They use both quantitative and qualitative evidence to substantiate their claims.
The central argument of this book is that capital inflows, perhaps attracted by rising interest rates, set the scene for financial disaster when associated with sophisticated, highly innovative securities markets. The capital inflow provides the resources, and the securities markets provide the venue in which those resources are deployed. The authors find that places with decentralized and less developed securities markets, like Canada, are less vulnerable to banking crises because the inflow of funds can be lent out via traditional loans to the domestic economy. Strong inflows and well-developed competitive securities markets together are a recipe over time for crisis. Banks engage in riskier behavior when they compete with sophisticated securities markets.
Although you might assume in societies with sophisticated securities markets that capital inflows would create a credit boom—a surge in the volume of bank lending—the authors’ findings do not support this claim. What they find instead is that credit quality deteriorates as banks lend to riskier clients, weakening the strength of their lending book. Borrowers with better credit, we assume, are getting their money from the securities markets. This finding led me to wonder whether focusing the analysis in this book on capital inflows was perhaps not particularly useful. It might have made more sense to have focused directly on the issue of credit quality. Rather than metrics of inflows, it might have been more telling had Copelovitch and Singer assembled a metric of financial mania instead. If the real issue is deteriorating credit quality, for which there might be a variety of causes in addition to inflows of capital, then it makes sense to go straight to the more proximate indicators of looming financial crisis.
The authors ask why banking crises occur and answer that they happen when banks’ customers lose confidence in them. Behind this is the challenge that all banks face: maturity transformation. Banks take deposits from their customers that can be withdrawn on demand. These are liabilities on a bank balance sheet. The assets—the loans made by banks—are made over a much longer time frame, with periodic repayment by installment. This makes banks vulnerable to a crisis of confidence, or a bank run, in which depositors collectively decide that their deposits are at risk and seek to withdraw them all at once. Traditional bank architecture makes the institutions look like classical temples to give banks at least the appearance of solid and venerable organizations, despite these inherent weaknesses. The authors describe how the collapse of Lehman Brothers led to the growth of uncertainty among counterparties that held Lehman’s debt, which then made banks wary of providing support to each other, escalating the problem.
What is unclear to me is why Copelovitch and Singer do not take the next step in the analysis and examine the shift away from relatively expensive bank loans to cheaper bond issuance. The costs of maturity transformation and the alternative of securities financing mean that since the 1980s there has been a process of disintermediation of wholesale financing, starting in the United States and moving on to Europe and Asia. Securities financing is now starting to invade the development process. For banks to compete with lower-cost securities financing, they must either lower the costs of their loans or take on riskier borrowers that cannot access the financial markets. In the process these banks, at the wholesale level at least, cease to be banks in the sense we have known them because of this hunt to bolster their returns. Their traditional business has been so disrupted that they become much more amenable to high-risk strategies that the old-fashioned bankers of the 3–6–3 model (pay deposit interest of 3%, lend at 6%, and be on the golf course by 3 pm) would never have contemplated. But this transformative story about banks worldwide is missing from the authors’ account of the causes of financial crises. Also missing are the other financial disruptors, especially social media companies, that are encroaching on the banks’ payments monopoly.
One of the fascinating issues considered in this book is the break in Germany between a world of persistent financial stability before 2008 and a new era of instability associated with Finanzplatz Deutschland. Copelovitch and Singer describe how Frankfurt became the focus of an initiative to compete with London and New York as financial centers. The effect, of course, as they describe it, was to transform Germany into an Anglo-American style financial system, in which securities and financial innovation have become much more important than they were traditionally. This has, Copelovitch and Singer show, changed the behavior of German banks, making them much more like those in the United States and United Kingdom and much less like those in Canada. It is a great story. But I think it could have been told better. This part of the book is precisely where fieldwork, especially elite interviews, might have drawn more sharply the motivations driving the change and the consequences for the new German financial industry.
The book’s final chapter considers the merits of a range of policy responses to financial crises. They issue a caution that, although global imbalances are a cause for concern, there are many more cases of capital inflows that do not result in banking crises than those that do. They go on to examine increased capital requirements, the imposition of capital controls, breaking up banks that are too big to fail, and the merits of reintroducing the Glass-Steagall separation of commercial and investment banking ended by the Gramm-Leach-Bliley Act of 1999, offering a series of thoughtful observations about the issues with these possible measures.
This last chapter is the most cautious one of the book. This makes sense because as political scientists the authors are accustomed to drawing conclusions from facts and from reasonable probabilities drawn from those facts. But it is also disappointing. I think in this final chapter Copelovitch and Singer might have allowed themselves greater freedom to think beyond the bounds of the existing policy debate, which seems not to have taken us very far from financial regulation as it existed before the global financial crisis, despite the Dodd-Frank Act of 2010. Much of the modest change since then has been focused on tightening regulative rules and increasing bank capital, even though the widely praised bank capital provisions in Spain did not save that country from catastrophic financial crisis after 2007. But surely the global financial crisis showed that financial innovation in securities markets can quickly outpace regulative rules.
In this context, perhaps we need deeper policy-making that addresses the conditions that allow for innovation to be undertaken in a safe way. The obvious comparison is with the chemical and pharmaceutical industries or with the training and regulation of medical professionals. Why do we tolerate less safety when it comes to finance, given the devastation that we know can follow a crisis involving these markets? The failure to regulate seriously following a crisis has involved an unwillingness to recognize the responsibilities that should fall on the shoulders of those who participate in these markets. When you consider the extraordinary incomes that some in banking and finance receive, this does not seem too much to ask. Despite talk of deglobalization, few countries have the choice to embrace a less efficient securities market like that in Canada, and all banks face pressure from disintermediation and new financial ventures inside the social media industry eager to disrupt banking.
Banks on the Brink is a well-developed study that makes a substantial contribution to the political economy of money and finance. The quantitative work and the historical case studies are thoughtful, clear, and insightful. The book underlines in the most compelling way how banks, in specific circumstances, can engage in disastrous behaviors and why they are compelled to do so. Although the authors might have done more to unpack the social mechanisms that make this so, they chose to frame this study in a more structural way. Subsequent work might usefully focus on precisely those social mechanisms.
