“The political process is far from neutral with respect to banking.”

Fragile By Design, by Charles W. Calomiris and Stephen H. Haber, is an important work in an important field: the history of financial institutions.1 Calomiris and Haber argue that banking and government are necessarily intertwined. Consequently, the propensity of banking systems to undergo crises depends crucially on the way that the political structure handles banking issues.

The authors point out that the essence of banking is the management of debt contracts. This necessarily creates a partnership with the state, which has ultimate responsibility for contract enforcement.

The fact that the property-rights system underpinning banking systems is an outcome of political deal making means that there are no fully “private” banking systems; rather, modern banking is best thought of as a partnership between the government and a group of bankers, a partnership that is shaped by the institutions that govern the distribution of power in the political system. (Calomiris and Haber, page 13)

… For a banking system to operate effectively, minority shareholders and depositors need the government to pass and enforce laws against tunneling [self-dealing by bank managers and majority stockholders], ensure that banks fulfill their contractual obligations, and create accounting standards and regulatory and supervisory agencies to facilitate evaluation of the bank by outsiders who are thinking of investing in bank stock or depositing their funds there. Similarly, the bank needs the courts and police to enforce loan and other counterparty contracts: without them, for example, collateral cannot be repossessed. (page 34)

The political process is far from neutral with respect to banking. Bank regulation is inseparable from credit allocation, which is of great interest to key constituents.

In fact, the group in control of the government typically has multiple conflicts of interest when it comes to the banking system. The most obvious conflict of interest is that this group regulates banks—ostensibly to limit banks’ exposures to risk—but also looks to banks as a source of public finance… .It therefore has incentives to fashion a regulatory environment that favors government’s (or government actors’) access to finance. (page 34)

For more on the Basel accords, see Why Financial Regulation is Doomed to Fail, by Philip Maymin. March 7, 2011, Library of Economics and Liberty.

We should not be surprised that the first international bank capital standards, under the Basel Accords, exempted sovereign debt from any capital requirements whatsoever.

The authors continue,

… the group in control of the government enforces credit contracts that discipline debtors… relies on those same debtors for political support. Nobody votes for the guy who just threw him out of his house and padlocked the door. (page 35)

Thus, even though in the United States a large percentage of homes purchased between 2003 and 2008 were obtained with little or no down payment, “foreclosure relief” proved to be very popular with politicians from both parties.


… the group in control of the government allocates losses among creditors in the event of bank failures, but it may simultaneously look to the largest group of those creditors—bank depositors—for political support. It is hard to stay in power when you tell the electorate that the banks lost their life savings and you are not going to do anything about it. (page 35)

If the largest class of creditors is protected, then either other creditors must have their contracts voided or, more likely, everyone is bailed out, with the burden placed on future taxpayers.

The authors study banking history in several countries, providing in-depth historical analysis of the United Kingdom, the United States, Canada, Mexico, and Brazil. They argue that the financial system of each country reflects its political idiosyncrasies. Here, I will focus primarily on the United States.

The authors posit a contrast between what they call liberal democracy and populist democracy. Liberal institutions are designed to limit the power of what James Madison called factions, in part by making the government relatively unresponsive to public clamor. Populist institutions are designed to increase the power of those who can command electoral majorities.

A central claim of the authors is that banking crises are more likely in heavily populist countries than in countries that are less populist. They cite Canada as an example of the latter. For instance, in Canada, Senators still obtain office by appointment, rather than by direct election.

The authors believe that liberal, Madisonian institutions serve to insulate bank regulators from political coalitions. They believe that the United States quickly succumbed to populism, with dire consequences for its banking system.

American populism fostered a tradition of “unit banking,” in which each town had its own quasi-monopoly bank. There were no national banks and states limited the number of branches any bank could have, with many states prohibiting branching altogether. These relatively lazy, non-diversified unit banks were naturally fragile, unable to withstand local economic shocks.

More recently, the authors argue, bank regulators were captured by the housing lobby and by community groups such as ACORN (the Association of Community Organizations for Reform Now), who pushed for regulations requiring banks as well as Freddie Mac and Fannie Mae to offer mortgages with low down payments to low-income borrowers. In order to induce lenders to provide these mortgages, the regulators set capital requirements that were low and easily evaded. The regulators did nothing to discourage the machinations of the credit-rating agencies, which granted AAA ratings to mortgage securities under the assumption that even under the worst of circumstances housing prices could not possibly fall.

The authors point out that Congress and regulators were indeed worried about how agencies were rating mortgage securities.

The concern, unbelievably, was that some of the ratings agencies were being too conservative in their ratings of mortgage-backed securities… legislation was passed that prodded the SEC [Securities and Exchange Commission] to propose “anti-notching” regulations that made it easier for sponsors to avoid the opinions of uncooperative rating agencies… The anti-notching rules that were passed in 2006, if they had been implemented, would essentially have forced each agency rating CDOs [mortgage-backed securities that required agency ratings] to accept the ratings of the assets of the CDO that had been provided by other agencies, without adjustment.

… In effect, Congress was forcing the more conservative ratings agencies to adopt the opinions of the least conservative. (pages 268-269)

The proposed regulations, which would have made AAA ratings even easier to obtain, were not finalized before the subprime crisis struck, at which point they were quietly shelved.

The authors do not believe that large banks are inherently a problem. Canada, which in its entire history has had no major banking crises, is dominated by a handful of large banks.

Nor do they believe that finance is inherently unstable. They explicitly reject the Minsky-Kindleberger thesis that “stability breeds instability.” Instead, the authors write,

… banking crises are not a regular occurrence across time and countries, and therefore they cannot be a consequence of any general economic characteristics about banks. Rather, they are the consequence of general economic characteristics about banks coupled to the specific political circumstances in which banks operate. (page 480)

For more discussion of Calomiris and Haber’s book, see the recent EconTalk live interview with Calomiris and Haber on Fragile by Design. For background, see also Financial Regulation by Bert Ely in the Concise Encyclopedia of Economics.

Overall, the diagnosis that blames the fragility of the American banking system on the susceptibility of the legislators and regulators to rent-seeking coalitions is sobering.

Citizens in a democracy may be able to shape the outcomes… To do so, however, they must achieve two daunting tasks. First, they must share an understanding of how the [system] produces distortions, rents, and subsidies. Second, they must coordinate their actions to enact lasting reforms that may be contrary to the interest of the coalition in control of the regulation of banking… It takes a great deal of time and effort to figure out what is going on under the surface, and even more to organize collective effort to achieve reform. For most people, mitigating the costs they bear as taxpayers probably isn’t worth the effort—especially since their attempts will likely meet determined opposition from the well-organized coalition that benefits from the status quo ante.

Let me conclude this review with some comments of my own.

1. The libertarian solution to the problem of tight links between banks and governments is to weaken government. To this, the authors raise two objections. First, they argue that a world without government-backed banks is a world of credit scarcity. Second,

… for better or worse—governments must create and allocate power: any government choosing to forbear from using banks as a tool to gain military and economic advantages would soon be replaced by a stronger government that did. (page 492)

It is possible that the authors are overstating their case. I wonder how Switzerland fits with their model. Switzerland strikes me as having a well-developed banking system that is not mobilized by the government on behalf of imperialist ambitions.

2. The authors do not directly confront the arguments of the proponents of free banking, including George Selgin.2

3. The authors somewhat short-changed their discussion of the political conflicts surrounding banking that emerged starting in 1960. For example, in describing the creation of Freddie Mac, they say that it “was designed to compete with Fannie Mae.” (page 230) In fact, that was not its original purpose. Freddie Mac was created in 1970 at the behest of California savings and loan associations, which faced high demand for mortgage loans but could not mobilize enough funds to lend, given deposit interest ceilings and the existing restrictions on interstate lending. In fact, consistent with the authors’ historical analysis, the creation of Freddie Mac can be viewed as an attempt to solve a problem caused by unit banking (the inability to funnel savings from the East to California) without abolishing unit banking itself.

Another aspect that is missing from the authors’ account is the tug-of-war between Wall Street and depository institutions. Some of the most important innovations, including money market funds and mortgage-backed securities, were deployed by Wall Street to invade the turf of the banks and savings and loans. This competitive pressure helped convince many bankers that the unit-banking model was no longer viable. From the mid-1970s to the mid-1990s, the focus of the financial industry and regulators was on the issue of a “level playing field,” with Wall Street and the bankers each lobbying to try to keep the other from gaining the upper hand. In explaining regulatory decisions of this period, I would assign more weight to the rivalry between Wall Street and depository institutions and less weight to ACORN and other community-action groups.

4. For two reasons, I believe that the authors come down too heavily on the side of those who blame the Community Reinvestment Act and the affordable-housing goals set for Freddie Mac and Fannie Mae. One reason is that there exists a literature that argues that these government quotas were not the marginal drivers of risky lending.3 Evidently, the authors did not find this literature persuasive, but they should have done more to address it.

Another reason not to insist that affordable-housing policy was at the root of the crisis is that one does not have to accept such a view in order to appreciate the authors’ central argument. They want us to understand that, in order to be effective, financial regulators must be insulated from special-interest pressure. I fear that many on the left may miss this point, particularly if they view the book through an ideological lens and are unduly put off as a result.


Charles W. Calomiris and Stephen H. Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Princeton University Press, 2014, 572 pages.

See Free Banking, by George Selgin, at the U. of Georgia, and Selgin on Free Banking, EconTalk podcast episode, Nov. 2008.

One example is Robert B. Avery and Kenneth P. Brevoort (2011), “The Subprime Crisis: Is Government Housing Policy to Blame?” Federal Reserve Board Finance and Economics Discussion Series 2011-36.


*Arnold Kling has a Ph.D. in economics from the Massachusetts Institute of Technology. He is the author of five books, including Crisis of Abundance: Rethinking How We Pay for Health Care; Invisible Wealth: The Hidden Story of How Markets Work; and Unchecked and Unbalanced: How the Discrepancy Between Knowledge and Power Caused the Financial Crisis and Threatens Democracy. He contributed to EconLog from January 2003 through August 2012.

For more articles by Arnold Kling, see the Archive.