Banks' failure

The aftermath of the banking crisis requires Nations think about not only the most appropriate form of banking legislation, but also the appropriate size of the state.

There has always been competition between different sorts of banking regulation. On the one hand, there is the idea- which defined banking for much of:

• In the American history- that banks should be close to the risks that they must judge. Here they were confined to one state. Most of nineteenth-century US banks did not have branches. They cannot distribute the risk. They had large intervention of political centralization.
• The alternate approach was that of Canada, which, because of its roots in secure British rule, had much less fear of political centralization, and was prepared to tolerate a nation-wide banking system. Canada’s large banking system distributed risk more widely, and also fared better in episodes of financial panic, whether in 1907 or in 1929-1933.
  

The larger bank principle has two chief attractions.

1. It promises more effective risk management, because large banks are less exposed to a single sort of customer (in contrast to rural American banks, which suffered when American farmers suffered).
2. It lends itself much more effectively to long-term strategic thinking about the overall direction of the national, or even the international, economy.

But the larger banks can get into trouble when these two principles get mixed up. The idea of the larger bank reached its high point in continental Europe, and especially in Germany, whose big banking system developed out of trade finance and into industrial finance in the late nineteenth century.

By that time, countries were looking with eager interest at financial models developed elsewhere. The most interesting and attractive potential model for the US was German-style universal banks, which were imitated in Russia, Japan, Italy, and Egypt.

By 1931, even Britain found it hard to resist the German model. By the 1990’s, however, emulation of other banking models was back in fashion. Financial empire building drove late twentieth-century globalization. There was a competitive race across the Atlantic and – to a lesser extent- the pacific.

Gradual integration of the potentially vast European capital market and the creation of cross-border European banks as a result of mergers, made it look as if a new European breed of super-banks was emerging. Likewise, Japan responded to its banking crisis by creating very large merged institutions, while the US repealed much of the depression-era legislation that restricted banking.

US exported its new banking model to the emerging- market economies. Spanish and U S banks moved heavily into Latin America.

But the new super-banks were inherently vulnerable because of the vast diversity and complexity of their transactions. Long before the emergence of the sub-prime mortgage problem, Citigroup was damaged by the behavior of its London traders, who tried to manipulate the European government bond market, and by its Tokyo traders.

It is much simpler for a transnational manufacturing corporation to implement controls to ensure product quality. By contrast, in a company whose business is financial intermediation, millions of judgments are made independently, and their implications may be serious enough to threaten the entire firm.

There is a danger that in the push to nationalize banks as a consequence of the financial crisis, governments will see it as their duty to implement strategies.