Sunday, 12 February 2017

Turner and Banking Crises

I adore John Turner, not only from the fact that he’s coming to Glasgow Economic Forum in four weeks (get your tickets here!), but for his great work in financial and economic history. Honestly, until April last year I didn’t even know he existed  borderline treason for those of us with an academic interest in financial history. As I stumbled upon his award-winning book, Banking in Crisis: The Rise and Fall of British Banking Stability, 1800 to the Present, I added it to my very long dissertation reading list. The extra push given by my advisor in September was enough for me to order it and read it. And what a read it was. Although the book is relatively short – 220 pages – it took me weeks to finish, for the simple fact that every single page contains valuable lessons, amazing reasoning and breath-taking insights that I simply had to jot down; my OneNote entry on the book is one of the largest I have and there are countless of individual entries in my vast Google Keep archive.

The praise for Turner's book came from many directions, like this from John Singleton in the Harvard Business History Review, almost straight out of my blog posts emphasising the value of econ history:
[Turner] constructs a persuasive argument, one that demonstrates the value of economic and business history as a framework for exploring and finding solutions to contemporary economic problems.
Or Richard Grossman, the celebrated banking historian, who says the following about this superb book:
Banking in Crisis combines the very best of serious academic scholarship and keen policy analysis. It should be required reading for anyone  expert and non-expert alike  who is interested in the past, present, and future of British banking. – Richard S. Grossman, Wesleyan University, Connecticut
I agree with him completely, and would place particular emphasis on the first two chapters (the best 34 pages of your economics education – honestly!) containing an outlook of his case and all you need to know about the elementary problems of banking. He goes beyond that and sketches out the theory of risk shifting, “a more complete theory”, that better captures the “behaviour of bank owners and managers, who ultimately make the decisions about a bank’s exposure to risk.” (p. 23). For the rest of the book, Turner takes you on a venture through the dozen-or-so financial crises since 1825. He uses bank failures and movement in bank share prices vs. the overall stock markets to trace out major and minor crises, and briefly dives into the eight major ones with a couple of pages dedicated to each crisis – a perfect introduction for somebody with limited knowledge of 19th century financial crises.

The rest of the book's chapters include more detailed discussions of lender-of-last-resort functions and Basel banking regulations, while a great overview for the initiated, may be a less-than-exciting read for normal people. So why should we care about banking? And moreso, why banking in history? Don't we have enough present banking issues on our minds?
Turner gives us four convincing reasons:
  1. Banks have important roles in economy; what happens to them affects us all, which the GFC dearly taught us;
  2. Banks are at the centre of the payment system and the monetary system “provid[ing] most of an economy’s money supply” (p. 3)
  3. Banking crises are rare enough occassions that we need to look at many of them to trace out a pattern  such attempts thus involve history. 
  4. Banks match lenders with savers ("provide intermediation of funds" in econ lingo), or as captured in a sentence: “Banking instability implies that these important services provided by banks are detrimentally affected, with potentially catastrophic consequences for both ordinary citizens and businesses” (p. 4). It’s a forceful justification on its own. 
He follows that discussion by supporting an interest in British banking in particular: Britain was first; British banking is believed to be more stable than other countries; Central banking pretty much originated here; minimal "statutory regulation of banking until 1979" makes recent development even more relevant; and finally the most important reason of all: British banking has mimicked many such developments in the rest of the world and may therefore provide insights and lessons applicable to other banking systems. 

I want to point to one more thing before I explain Turner's main case: the epic Monopoly introduction. Literally the first paragraph that strikes the reader is an anecdote to his childhood, where he draws on the important lessons about banks implied in the game: 


It's a great representation for his entire work: insightful yet down-to-earth, easily explained and easily comprehended. The case is all-encompassing and gives a great overview to the study of banking problems, with Britain’s last two centuries as a case study.

Now, what's his point?

The basic case is this: banking can be kept stable and away from recurrent crises of various sizes in two ways: first, by extensive owner liability where share-holders are liable for more than the initial value of their shares – which ensures prudently-run banks – or second, by repressive government financial regulation that prohibits banks from advancing much funds to the private sector. The first one requires wealthy owners willing to take on that kind of extended liability, as well as a monitoring and screening process of owners that would be unthinkable in modern-day financial markets. The second carries a very high cost to society in terms of lost output and credit intermediation, invalidating the entire reason for a banking system. The lesson from two centuries of British banking stability is clear: one or the other is sufficient to ensure stability. Neither eventually means costly crises.

These are the relevant paragraphs, reproduced in full in order to illustrate Turner’s clear structure and mesmerizing writing style:
“Banking is an intrinsically risky business, and the reason is simple: bankers lend other people’s money, not their own. This creates an incentive problem because bankers get most of the benefit if the risky loans they make do well, whereas depositors, not bankers, incur most of the costs if loans go bad. Unless it is addressed, this incentive problem eventually results in unstable banking. The basic argument advanced in this book is that banking is at its most stable when one of two conditions exists, both of which address this intrinsic incentive problem at the heart of banking:

“The first condition is that bank shareholders are held to account for bank failures. What does this mean? The basic idea is that when bank shareholders stand to lose substantially from a bank failure, they will ensure that their bank is properly and prudently run, thereby greatly reducing the probability of it failing in the first instance. As a result, bank depositors are assured that their deposits are safe because bankers have an incentive to ensure that they are judicious in their treatment of depositors’ funds.” (p. 6)

“The second condition under which banking is at its most stable is when banks are constrained by onerous government controls. For example, banks could be required to hold a significant amount of low-risk government debt and be restricted from lending to risky or speculative sectors of the economy. Such onerous restrictions place bankers in a figurative straitjacket, which severely constrains their proclivity to take excessive risk and thereby keeps banking stable.” (p. 7)
I highly recommend his other work on limited liability and 19th century financial markets, but they deserve reviews of their own. Until then, check out Turner's book  or even better, show up for Glasgow Economic Forum on March 11-12 to discuss the material with Professor Turner in person!

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