2013 Financial Markets Conference

April 2013

An interview with Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia University

Kris Gerardi: Welcome, thank you for watching. We are here today with Charles Calomiris, the distinguished Henry Kaufman Professor of Financial Institutions at Columbia University, to discuss the link between banking and politics. So let's get right into it.

It seems like the most unstable banking systems and the banking systems that are characterized by the least amount of credit allocation are autocracies, specifically, autocracies with extremely weak property rights. Yet, on the other hand, it also seems clear that democracy is not a sufficient condition for achieving a stable and efficient banking system. I was struck by when you looked within democratic countries, there's a ton of heterogeneity and variation in terms of credit allocation, as well as stability. What is the underlying factor there that I'm missing?

Charles Calomiris: I think what you said is correct. It's pretty easy to see in some autocracies why banking can't develop. If you're in the middle of a civil war, or you have some sort of constant chaos, like a Mexican revolution, it's not a big shock that there are no banks. In a lot of periods in autocratic histories, during those kinds of military events, there's no banking at all, and you can see why. If you set up a bank, some group of soldiers is going to come in and take the money.

So in a chaotic situation where no real government's established, you're not going to get it. And then you start thinking, well, what if an autocrat manages to run a country in a very dictatorial way? How are you going to feel comfortable putting money in a bank because if he's got all that authority, he'll just take the money himself, right?

So you can see that then what happens is autocrats partner with some group of, for lack of a better word, cronies. And that partnering, though, is difficult because how does the autocrat commit not to just take the money? And that is not an easy-to-solve problem. They do it in a variety of ways by creating certain mutual dependencies. But ultimately, the autocrat can't commit not to take the money in some situations: wars, revolutions, whatever. That means that the only way to get people to participate is to give them monopoly rights. And that means that inherently, autocratic banking systems are not only stable, but they tend to have scarcity of credit because it's the only way to get participation through those same principles of enforcement. And so if you can't have really good rule of law, then you're going to have scarce credit.

Now, in democracies, the problem's different. Because you have a democracy, you can be pretty clear that expropriation is going to be not a personal act of an autocrat, but it could be the act of a majority. And it could be done in a whole bunch of subtle ways; regulation can be a form of expropriation, I could say nobody named Kris gets to borrow, and that expropriates you, or I could say banks have to make much bigger contributions in taxes. In democracies the problem is, how does the group that wants to be involved in the banking system—how does it protect itself against majority tyranny?

And the real problem in banking systems within democracies—the heterogeneity comes from how much you have this risk of kind of populist majority grabbing. The key problem in these democracies is that some group puts together a coalition with the government to use the banking system to effectively bias the rules, or, if you like, expropriate through the regulatory process, the losing coalition that doesn't get to control the banks. And we think that's a very good characterization of U.S. banking history since about 1830.

Gerardi: On the topic of the U.S. banking system, you refer—and let me make sure I get this straight—to the agrarian populist unit banking coalition as one of the root causes of the instability in the U.S. banking system going all the way back, I think, to 1830 and through 1980. What exactly do you mean by that term?

Calomiris: The U.S. was just a bizarre banking system for 150 years, unlike any other banking system in the world. We had this vast continent, and instead of having banks that could operate across state lines or even across locations within the same state—diversifying their risk, achieving economies of scale—instead of that we had unit banks, that is, one office is the bank. And, of course, that has huge overhead costs. It tends to mean that people in rural areas, in the most sparsely populated rural areas, don't have very good access to credit. It's really kind of a losing system from a whole bunch of standpoints, and it's not a very competitive system because those overhead costs of setting up a bank are so big it means that you get to be the only guy, or one of two or three guys, in the area you're operating.

There wasn't a lot that economic historians or economists or finance people or bankers have ever liked about that system, but that system was incredibly politically durable and it lasted despite all of the things that almost undid it over and over again based on efficiency grounds. But efficiency got trumped by politics, so there was a very powerful coalition.

Now, "agrarian populist" should invoke people like William Jennings Bryan. William Jennings Bryan was a big advocate of unit banking. It should also invoke people like Henry Steagall in the 1930s. So we had a long history of—going back to Andrew Jackson and coming all the way up, really, through the 20th century—of advocates that believed that it was good to have local banking. It's a long story about why, but that coalition fell apart as a result of several things that happened, really over several decades (but culminating in the 1980s), and it had to be replaced by something else.

Gerardi: This feeds right into my next question: what replaced it, and to the extent it was replaced by a different coalition, how has that coalition shaped what we see today in terms of the banking system?

Calomiris: So as the banking system is experiencing trouble in the 1980s, the larger banks in some of the states that allowed statewide branch banking, 'cause there were a few—who were they? California, Ohio, Arizona, North Carolina. So when the problems started, there were some banks in obvious locations: Bank One in Ohio, NationsBank in North Carolina, who were saying, "Well, why don't you let us expand and we'll take some of the losses away from the FDIC." That was a win-win, and it helped make this strategy work. But as those banks were expanding, and during the late '80s and especially the 1990s, as these large banks started to want to develop these nationwide franchises, those mergers had to be approved and they were somewhat controversial.

In the 1990s it became clear to a group of community groups—let's call them activist groups—that they had a voice as a result of the Clinton administration's buttressing of the Community Reinvestment Act [CRA]; they had a voice in the bank merger process. So they could hold out, basically, to get the banks to agree and it turned into specific promises in exchange for support. So that support amounted to contention support as part of specific written agreements that would help banks get the mergers they wanted: almost a trillion dollars. And by the time the CRA compliance of the 1990s was done, the total amount of dedicated funds coming from the banking system for CRA compliance was about $4.5 trillion. And at least half of that wouldn't have happened without this sort of coalition.

What's interesting—I think it's very important for understanding the crisis we went through—is this wasn't just a big-bank political conspiracy. The big banks had a lot of allies because they were creating rent-sharing arrangements. They got the mergers, the mergers created what we call an "economics rent," but then they had to share some of that rent with various groups. The problem was that the sharing of that rent also tended to push them in the direction of having to relax their underwriting standards. And that became especially true over time as they're digging deeper and deeper to meet those commitments. The initial reaction, especially as Fannie and Freddie got dragged into this politically to help market those commitments, those loans, was, "Well, we need to relax our underwriting standards." But then if you're relaxing your underwriting standards, you can't exclude other people.

So what you end up doing is creating a new normal, which is 3 percent down payments—which become 40 percent of originations by the end of the precrisis period—nondocumented mortgages—that was a big change in 2003 that Fannie and Freddie underwent, that basically they removed their caps on nondocumented mortgages because it was the only way they could satisfy their mandates. And, by the way, we know that because of the internal e-mails at Freddie Mac that documented the fact that they were doing that so that they could meet their mandates. So the financial system got sort of drawn into a political deal between activist groups and too-big-to-fail banks. Now, of course, that's not to say that the whole subprime crisis was caused by that deal, but that deal definitely contributed to the reduction of underwriting standards, which then became extended to everyone, and which then contributed pretty significantly to the problem.

So it was kind of interesting, going back to the previous question, you had the previous arrangement between agrarian populists and unit bankers replaced by the new sort of urban populists and too-big-to-fail bankers. What's also interesting is that this was not a partisan divide, but it was an urban-rural divide.

Gerardi: So you have a recent book that's coming out in September, I think, which kind of establishes and develops the link, the causal connection, between the stability and efficiency of a banking system and the political structure of a society. Now, at least in my reading of the academic literature, at least with respect to economics and finance, there really has been little done on this link. What brought you down this road?

Calomiris: It's a coauthored book with Steve Haber, who is a political science professor at Stanford. We had both been thinking very broadly about the fact that, in the modern world, the relationship between banks and the state is fundamental; that is, banks rely on the state—absolutely—to enforce the property rights that are key to banking.  You have to protect against expropriation. You have to protect to ensure enforcement of loan contracts. You have to protect against the fraud by the banker. All of this requires active involvement by the government.

Different kinds of political systems address those problems in different ways. We realized that those differences translate into persistent—and really you might call them "political equilibrium"—differences in the extent to which banking systems can provide abundant credit, and stable credit. It's been about a four-year project now where we've been working through the last 400 years of history of five countries in some detail: the U.K., the U.S., Brazil, Canada, and Mexico. When you go through those five countries for those 400 years, you pretty much end up, we found out, spanning all the relevant possibilities. We think we ended up with sort of a general framework. We didn't really start off thinking we were going to get there. We were just going to write some histories, but I think we ended up with a pretty general framework.

Gerardi: Excellent. Well, on that note, we'd like to thank Charles for joining us today, and we'd also like to thank all the viewers for watching. Thank you.