Are Banks Inherently Fragile?

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In a previous post, I argued that a useful analogy for thinking about banks is to think of them as a coalition of depositors. This idea isn’t literally true, but it does help one to think about the relevant issues related to fractional reserve banking.

To review this idea, you can think about a bank as serving two purposes. Savers would like to be compensated for forgoing future consumption. In the absence of banks, they could do this by purchasing shares in a company or lending money to a company or an individual. There are several possible issues here.

One issue is the risk involved in this strategy. If the saver has a lot of money to save, he or she might be able to protect against this risk through diversification by buying shares in lots of companies or lending money to a lot of different people. The average saver is unlikely to be able to diversify in this way — at least not all at once.

A second issue is that each individual saver might want to save, but something unexpected happens and suddenly the saver needs his or her money back. If the saver has given this money to another person or a firm, he or she might not be able to get the money back.

Banks aim to solve these problems by serving as an intermediary between borrowers and lenders and the bank issues liabilities that serve as a medium of exchange. The bank does this by pooling all of the money from savers together. It then sets some fraction of that money aside in case any of the depositors come back and want their money. The rest of this money is used to fund loans.

Ideally, the bank will be able to diversify its loan portfolio to protect depositors from the risk that people default. (Furthermore, since shareholders finance some fraction of the bank’s assets, they are the ones who suffer the initial losses if the bank does a poor job of diversifying.) But the bank should also diversify its depositor base. The entire idea behind allowing depositors to show up any time they want and get their money back is predicated on the belief that not everyone is going to do that. If there is a diverse pool of depositors, the demand for liquidity right now should be random and idiosyncratic. If the demand for liquidity among the pool of depositors is correlated with one another’s demand, then this won’t be true and the bank will face the prospect of a run.

Some people look at this sort of thing and view banks as inherently fragile. After all, if everyone just shows up all at once to get their money, the bank won’t have the money. This run on the bank could cause a bank failure.

However, that view leaves several questions unanswered. For example, why would everyone all of the sudden run to the bank to get their money for no apparent reason? Are bank failures caused by bank runs or are bank runs simply a consequence of people learning about bank failures? If banks have these characteristics, surely bank managers know of these characteristics. Wouldn’t the people operating the bank have an incentive to behave in a way that prevents bank runs?

The view that banks are inherently fragile seems quite prominent in the United States, even if only implicitly so. I often hear very smart people argue that financial crises are simply regularly occurring phenomenon. Every couple of decades, society is simply “due” for a crisis. But is this true? The U.S. has certainly had its fair share of financial crises, but does that teach us something about banking and finance or does that teach us something about the U.S.?

An interesting alternative to the inherent fragility argument is what George Selgin referred to as a legal restrictions theory of banking crises. According to this view banking crises can be understood as the result of shocks caused by government-imposed restrictions on bank operations or the inability of banks to respond adequately to external shocks due to these restrictions.

We can think about this in the context of our idea of banks as coalitions of depositors. As I argued above, this view suggests that the bank should want to diversify both its loan portfolio and its deposit base. Similarly, as I noted, the bank has to make a decision about how much money to set aside as reserves and how much money to lend out.

Historically, the U.S. had regulations that prevented banks from accomplishing these goals. The clearest example of this is to note that for much of its history, the U.S. had restrictions on branch banking. In some states, banks were prohibited from having more than one location. In other states, banks were only permitted branches within a particular state. If we think about banks as coalitions of depositors and the important role of diversification, such restrictions not only prevent banks from diversifying their loan portfolios, but also prevent them from diversifying their depositor base. If a bank is only allowed to have one branch is west Texas, then most of the loans will be to oil companies and a lot of the depositors will be employees of those companies. A shock to the price of oil is therefore likely to cause a banking crisis.

Another example of limitations placed on bank behavior was the restriction on note issuance during the National Banking Era. During this time, banks issued their own bank notes. The banks were required to back some fraction their notes with government bonds (despite the fact that the notes themselves were redeemable for specie). This requirement that notes be backed by government bonds meant that when there were fluctuations in the demand for money, banks weren’t always able to meet those demands. As Bruce Champ, Bruce Smith, and Steve Williamson showed, this sort of restriction on note issuance could cause bank failures because it causes a drain on reserves. When they examined the data, they found that loans in Canada tended to increase during “crop-moving” times whereas loans tended to decline and interest rates tended to rise during these times in the U.S. They also found that banking panics in the U.S. corresponded with increases in note issuance in Canada and the absence of Canadian bank panics.

Overall, George Selgin separated banking systems across countries into the categories "free” and “unfree” based on the legal restrictions in these countries. What he found is that the “unfree” systems had more numerous and more regularly occurring banking crises than their “free” counterparts.

These examples are illustrative of the problems imposed by legal restrictions on banking. One should therefore be careful to conclude that banks are inherently fragile on the basis of the U.S. banking experience. Of course one must also be careful not to let the pendulum swing too far and conclude that if bad regulation explains bank crises in the U.S., then it must also explain bank crises everywhere. Yet, as Charles Calomiris and Stephen Haber argue in their book, Fragile By Design, there does seem to be ample evidence that banking crises are driven by legal restrictions and the regulatory regime.