Charles Calomiris and Stephen H. Haber Fragile By Design:

The Political Origins of Banking Crisis & Scarce Credit

“The United States has had 14 banking crises over the past 180 years! Canada, which shares not only a 2,000-miles border with the United States but also a common culture and language, had only two brief and mild bank illiquidity crises during the same period.” And since 1839 Canada “has experienced no systemic banking crises1.”  

In this well-researched book, Charles Calomiris and Stephen Haber, economics professors at Columbia and Stanford Universities, respectively, explain what is responsible for the difference. In short, different countries have different banking systems as a result of the differences in the political bargains struck between political coalitions in different countries or in the same country at different times. It is the result of what the authors call the “game of bank bargains.” 

“Bankers” have been around for more than 4,000 years, initially as lenders, then deposit takers and moneychangers. However, the resources of a wealthy individual – or even partnership – could not facilitate the growth in manufacturing and trade that followed the industrial revolution.

That required the invention and establishment of the joint-stock company with limited liability, which governments began to grant via bank charters. The privileges granted in these charters, and the services provided to the granting government and political supporters in exchange, constitute the Game of Bank Bargains and determine the nature of the banking system that results.

The role of rent creating and sharing arrangements among interested groups are illustrated with fascinating details from the history of banking in the United Kingdom, the United States, Canada, Mexico and Brazil. Most often, governments granted special privileges to banks in exchange for their helping the government finance a war. The Bank of England, for example, was chartered in 1694 as the only limited liability joint-stock banking company and given other monopoly privileges in exchange for lending to the crown at low interest rates.

However, for American readers, the strange evolution of a very unstable and inefficient system dominated by unit banks (no branches) and its transformation into a small number of national megabanks and government-sponsored enterprises (GSEs – Fannie Mae and Freddie Mac) is nothing short of spellbinding.

The housing bubble and the Great Recession are revealed in a new and illuminating light. From America’s largely agricultural and state chartered banking origins (the U.S. Constitution prohibited states from issuing currency but not – Article X – from chartering banks), community banks and the states that chartered them had a mutual interest in preventing branching and especially interstate branching and the competition it would bring. “In 1914, there were 27,349 banks in the United States, 95 percent of which had no branches.”2

Thus, the United States developed a fragmented, fragile and inefficient system of thousands of small unit banks. The rent-seeking interests of these local banks and the governments that chartered them were not the same as the general public’s interest in good banking services. Who wins the Game of Bank Bargains depends on who has the political power and votes to sell.

With the decline of the political clout of the populist agrarians and the increasing costs of a poorly structured banking system, the restrictions on interstate branching and the local banking monopolies they made possible were finally swept away by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (IBBEA). This launched a massive consolidation of banks operating nationally, with the total number of banks dropping below 7,000 today and falling.  In addition, economic regulations of banks (e.g., Reg Q interest rate ceilings, unit banking) were significantly liberalized between the late 1970s and 2000, further strengthening the stability of the banking system. There was, however, no reduction in prudential regulation, though regulators often failed to use the powers they had to limit risk or increase capital.

At the same time, political movements promoting home ownership and income transfers to the poor in the form of subsidies for home ownership gained wider support.  Community activist groups such as the Association of Community Organizations for Reform Now (ACORN) that had long advocated lowering lending standards to those in poor, and often black, neighborhoods found a champion in newly elected President Clinton. Under Clinton, the Community Reinvestment Act (CRA) was strengthened and Fannie and Freddie where mandated to increase the number of subprime mortgages on their books or that they guaranteed. To do so, they dramatically lowered their mortgage lending standards for everyone (3 percent down payments, no documents of income, etc.).

In exchange for lowering their mortgage standards, the GSEs – by then privately owned – were exempted from normal capital standards and implicitly guaranteed by the government – made explicit when they were later declared bankrupt. In July of 1999, President Clinton bragged that: “Over 95 percent of the community investment … made in the 22 years of that [CRA] law have been made in the six and a half years that I have been in office.”3

The final plank in this tawdry story – which was much nastier than summarized here – was the need for the Federal Reserve to approve bank mergers and acquisitions on the basis, in part, of an assessment of the acquiring bank’s performance in achieving CRA goals of increased subprime lending. Banks joined with the likes of ACORN in order to expand such lending, in exchange for which such organizations supported the banks’ merger and acquisition applications.

It is acceptable to invest in riskier assets if banks increase their capital cushion appropriately. In the days of largely unregulated banking and no deposit insurance, banks held capital of 40 to 50 percent of their assets in order to convince depositors that they were safe. But today’s regulated banks were able to manipulate their mortgage business (via the GSEs and securitization) to avoid any regulatory requirements to increase capital. Bank shareholders were willing to go for the expected higher, but riskier, return and creditors were willing to let them because of deposit insurance and the expectation of a government (tax payer) bailout if things went wrong, as they subsequently did.

The government could not require banks to increase their capital against riskier mortgages without undermining its policy of promoting (subsidizing) those mortgages, a conflict of interest with devastating consequences.

The otherwise inexplicable collapse in lending standards and the financial crisis that followed is explained by the economic rent sharing collaboration between political groups like ACORN, the government, the GSEs, and the emerging megabanks to promote home ownership among those previously unable to qualify for a mortgage. The government and its political supporters achieved their political objectives via mortgage subsidies without adding line items to the Federal budget, until the bailouts were needed. Fannie and Freddie gained huge profits for a while, and high salaries and employment for political friends, backstopped by government guarantees.4  Megabanks achieved (bought) the Fed’s approval of their merger goals while shifting the risks onto the taxpayers. Is that sleazy or what? It is called crony capitalism to distinguish it from the real thing.

Canada’s banking system is superior to that of the U.S. in virtually every respect. Canadian banks provide more credit relative to GDP than do U.S. banks – 75 percent vs 45 percent – and have been more stable. While average loan rates are about the same as in the U.S., the geographical differences are much smaller in Canada (i.e., lendable funds are better distributed) and average deposit rates are higher. Despite the narrower deposit/loan spread, Canadian banks are more profitable.

The reason is the difference in the outcomes of the Game of Bank Bargains. Though special interest and regional groups have challenged Canada’s banking laws and regime, Canada’s history “gave rise to a regulatory system in which the central government held a monopoly on the right to charter banks. Provincial governments could not create local, territorially demarcated banks that could serve as the nucleus of an anti-national bank coalition, as happened in the United States.”5

The key features of Canada’s banking regime “included a limited charter duration [with simultaneous review of the banking law], the right to issue notes against the general assets of the bank, the right to open branches nationwide, and the requirement to disclose accounting information to the government.”6

The need to transport produce and products across the continent for export to Europe was facilitated by and encouraged the development of extensive branching of a small number of national banks. No Canadian banks failed during the Great Depression. Canada had no central bank until 1935, which did not have a monopoly of note issue until 1944. Canada resisted deposit insurance until 1967. Its banks have consolidated and now consist of six nationally chartered banks. In addition to these factors, the high level of service and profits reflect “Canada’s generally less-restrictive regulatory environment ….”7

Canadian officials understood clearly the dangers of deposit insurance. A report by the Canadian Department of Finance stated that the mutual guarantee of bank deposits “has proved unworkable in the United States and is basically unsound as it means that the conservative and properly operated bank would be called upon to bear the losses through mismanagement, fraud, and otherwise incurred by competitors over whom it has no control. The final outcome would only be a disaster as the public would not be called upon to discriminate between sound institutions with whom their funds would be safe, and the others.”8

The authors further illustrate their Game of Bank Bargains thesis with the financial histories of two (then) non-democratic countries – Mexico and Brazil. In the penultimate chapter, the authors review a number of empirical studies of a much broader range of counties, thus adding a different type of evidence in support of their basic premise. For example, “a broad literature on deposit insurance …” concludes that “the more generous the safety net, the more unstable the banking system.”9

“Philip Keefer finds not only that democratic political institutions are robustly correlated with the growth of bank credit but also that democratic political institutions work by providing more secure private-property rights.”10 

Thus, it is interesting to note that in Chile, Augusto Pinochet, a military dictator, “did not have to convince the population that his dictatorship was not a threat to their property rights. Rather, the threat to property rights had come from the left-wing democratic government that he had overthrown.”11

The ultimate question, of course, is what is the best legal and regulatory framework in which to develop efficient (payments and credit allocation) and stable banks, and how to adopt it? Opinions and evidence on the first question are turning toward greater reliance on market determination of bank business models and market discipline of bank risk taking (e.g. bailing in rather than bailing out creditors of failing banks). Unfortunately, the authors say little about the role and impact of the Basel Core Principles for Effective Banking Supervision as a distillation of best practice.

But just as national level chartering of banks offers greater protection against the domination of special interests when drafting and enforcing banking regulations, the development of standards by an international body, such as the Basel Committee for Banking Supervision, adds another layer of protection over purely national standards. In fact, diverse domestic practices that reflected their own Game of Bank Bargains delayed the development of international bank capital standards (Basel I) from the early 1980s until the adoption of the Basel Capital Accord in 1988.

With regard to the second question – how to adopt best practice – virtue does not come easily. “The extent of safety nets and prudential regulation are choices made by politicians, and in making those choices they are generally motivated by maximizing what is good for their own short-run political futures, not what is socially desirable in the long run.”12 

“Economists and others who study banking and hope to improve banking systems performance must learn to think about banks, and the potential desirability of reform proposals, in the context of the political and technological environment in which banking outcomes are determined.”13

“Within a democracy, to sustain effective reforms in banking, more is needed than good ideas or brief windows of opportunity. What is crucial is persistent popular support for good ideas.”14

This is not easy, to be sure, but the benefits are enormous.

Calomiris and Haber have made an important contribution to their subject, which is bound to become a classic.  


  1. Calomiris and Haber, page 5.
  2. Ibid. page 181.
  3. Ibid. page 217-8.
  4. Robin “Seiler concluded that much of the government’s subsidy to Fannie and Freddie was passed to their own stockholders rather than to homeowners in the form of lower mortgage interest rates.” Ibid, page 248
  5. Ibid. page 286.
  6. Ibid. page 299.
  7. Ibid. page 319.
  8. Ibid. page 311.
  9. Ibid. page 461.
  10. Ibid. page 459.
  11. Ibid. page 476.
  12. Ibid, page 483,
  13. Ibid. page 486.
  14. Ibid. page 504.