Fragile by Design: The Political Origins of Banking Crises and Scarce Credit

Fragile by Design: The Political Origins of Banking Crises and Scarce Credit

Po-Keng Cheng (Department of Applied Mathematics and Statistics, State University of New York at Stony Brook, Stony Brook, NY, USA)
Copyright: © 2016 |Pages: 5
DOI: 10.4018/ijabe.2016010103
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This paper provides review for which demonstrates the links between politics and banking. In addition to the perspective in , several recent studies relating to financial crisis are also introduced here. Issues about illiquidity, insolvency, credit boom, accuracy of credit rating, and neglected risk are discussed. Banking system is the bridge connecting households and sectors in the economy, where the design of the banking system has significant influence on the developments of countries.
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Review Of Book

The book, Calomiris and Haber (2014), is for the readers who have interests in the history of banking system evolutions in the modern era and would like to know more about how politics can shape banking‐system outcomes. The Game of Bank Bargains is the key concept connecting each chapter in the book. From their point of view, the government‐banker partnership is no avoiding, and the conflicts of interest inherent in this partnership can make the banking system fragile by design. When bankers raise deposits and equity capital to finance their operations, they need government to grant their privileges (the bank charters). By granting the charters, government requires a set of obligations for banks, including taxes on bank profits or capital, maintaining sufficient holdings of government fiat currency and bonds, and submitting to government supervision. The bank charter enables bank to create money that serves as a legal tender for its payment, hold government deposits, and declare limited liability for its shareholders.

However, the conflicts of interest among government, bankers, bank shareholders, depositors, debtors, and taxpayers are interdependent and unavoidable. Bank shareholders and depositors have to create mechanisms either for preventing the bankers from expropriating their capital or compensating bank shareholders and depositors for the risk of expropriation. Similarly, banks and government, also banks themselves, have to create mechanisms either for preventing government and debtors from expropriating banks or compensating banks for the risk of expropriation. The government is not a disinterested and unitary player. For example, in order to gaining political support from the electorate, the group in control of government may allow banks giving the senior creditors a haircut for keeping the banks running and also the deposit base undamaged. Moral hazard then occurs while banks are given incentives to take wild risks. In the even worse case of bank failures, government may decide rescues and bailouts of banks under the bills of taxpayers (Calomiris and Haber, 2014).

The authors (Calomiris and Haber, 2014) illustrate the Game of Bank Bargains with several countries’ outcomes of banking systems in different time periods, such as England’s financial repression from the late 1700s to the early 1900s, U.S. banking from Colonial times to 1990s, and Banking and State Finance in Imperial Brazil. Credit scarcity and banking instability can be viewed as equilibrium outcomes resulting from specific political institutions within which banking systems are constructed. Generally speaking, autocracies tend to produce unstable banking systems with limited entry and scarce credit, while democracies tend to induce stable banking systems with relatively open entry and more abundant credit. In short, the Game of Bank Bargains is the struggle among political coalitions, which determines the rules for all the participants in the banking system.

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