History Repeats in Financial Ideas - and Crises
Many American financial managers and commentators are innocent of banking history. Therefore, while cyclically reliving financial crises, they rediscover financial ideas.
Let us consider some examples:
* The dangers of real estate lending.
* The dangers of deposit insurance.
* The advantages of nationwide branching.
* The risks of foreign lending.
The Realty Swamp
Current financial discussions dwell on the overexpansion of real estate credit and the consequent massive losses: one of the lessons of the 1980s, it is said. Yet when the recent real estate lending euphoria was under way, it had only been a decade since the massive real estate bust of 1975-1976.
Other past financial crises also featured real estate:
"The failures for the current year have been numerous, many having been characterized by gross mismanagement and some by criminality. ... In many cases, however, the unfavorable conditions were greatly aggravated by the collapse of unwise speculation in real estate."
Do these comments sound familiar? They are excerpts from the "Report of the Comptroller of the Currency" in 1891.
Or consider the following description of 1932 from Jesse Jones, head of the Reconstruction Development Corp.:
"Strewn all over was the wreckage of the banks which had become entangled in the financing of real estate promotions and had died of exposure to optimism."
Reacting to the current real estate problems, some commentators suggest reintroducing the 70% limitation on bank loans against the appraised valued of real estate collateral.
The Cautious Alternative
A more careful approach was taken by the liberalizing McFadden Act of 1927: to allow national banks to lend up to only 50% of value against real estate (the same limit as for the issue of bank notes against real estate collateral as in the New York Banking Act of 1838).
The grand prize for optimism and unintentional comedy goes to the Wall Street author of a July 1991 article on real estate, who said:
"Lenders are unlikely to repeat their past mistakes."
The first bill for federal deposit insurance was introduced by William Jennings Bryan in 1893. Eugene White ("The Regulation and Reform of the American Banking-System - 1900-1929") recorded that "conservative bankers were adamantly opposed to deposit insurance."
One conservative banker, James K. Ilsley, president of the Marshall & Ilsley Bank of Milwaukee, spoke against deposit insurance at an American Institute of Banking meeting in 1910:
"I presume few, if any, members believe in the guaranty of bank deposits. You are students of financial questions and are not likely to be easily misled."
No Allowance for Honesty
The key point, then as now, he stated thus:
"The guaranty of deposits means, in effect, the guaranty of loans. It places bankers on the same dead level, no allowance being made for character, ability, training, efficiency, honesty.
"A guaranty law makes all bankers, in the public estimation, equally good. It gives to the reckless banker an opportunity to secure a large line of deposits which he could not have secured upon his own strength."
Mr. Ilsley discussed the following aspects of what had happened in Oklahoma, which had state deposit insurance:
* An oil speculator in control of a bank.
* Marketing deposits based on deposit insurance, paying interest rates well over the market.
* "Loans on easy terms" to friends.
* "Mushroom growth."
* Bursting of the bubble.
* Exhaustion of the cash of the insurance fund.
* "Partial and deceptive statements" from the responsible banking board.
* Increased assessments of the other banks to make up the deficit of the insurance fund.
Is that 1910 or 1991?
No complaint has been more common in the savings and loan industry or is becoming more common among commercial banks than that it is unfair to charge good institutions to pay for the mistakes of the bad.
Yet this result of deposit insurance was well known to our banking ancestors. As one of them rhetorically demanded 80 years ago:
"Is there anything in the relations existing between banks and their customers to justify the proposition that in the banking business the good should be taxed to pay for the bad; ability taxed to pay for incompetency; honesty taxes to pay for dishonesty; experience and training taxed to pay for the errors of inexperience and lack of training; and knowledge taxed to pay for the mistakes of ignorance?"
And here we are.
For almost 50 years federal deposit insurance was thought to be an unqualified success. Its problems are now only too apparent.
The Treasury Department has formally proposed nationwide bank branching in order to create more diversified loan portfolios and sounder financial institutions. The "Economic Report of the President, 1991," observes that geographic restrictions "prevent banks from diversifying efficiently, make banks and thrifts less safe," and are "obstacles to the efficiency, profitability, safety, and soundness of the financial sector."
The American banking system has demonstrated anew that geographically concentrated banks and banking systems run into problems of the most severe sort when a regional economy declines.
But this was well understood nine decades and five banking crises ago.
The "Economic Report of the President" also suggests:
"If local banks or thrifts are the only sources for loans, contraction in lending might exacerbate the local economic downturn. On the other hand, a well-diversified bank or thrift could easily absorb loan losses in a single community and continue to lend to creditworthy borrowers."
Reservoirs of Credit
A.P. Giannini, the founder of Bank of America, said it more forcefully in 1924:
"Under nationwide branch banking, an enterprise located in either the big city or the small village would have equal potential reservoirs of credit. Borrowing power would be independent of local conditions.
"A section distressed through crop failures, floods, unemployment, or for any other reason, would experience no diminution in its local financial support. ... The amount of distress would be lessened and recovery greatly speeded up."
Sixty-seven years later, we are approaching the same idea (and BankAmerica Corp., as it did in the 1920s, is making interstate acquisitions).
In Praise of Foreign Lending
With some effort, we can remember that a chorus of bank managers, central bankers, and journalists praised the great foreign lending expansion of the late 1970s as a successful "recycling of petro dollars." They discovered that the risks did not cycle, but stuck as large claims against bank capital. After nearly a decade of continuing crisis in the debt of lesser-developed countries, we have become accustomed to the fact that these loans are worth 30 cents or 40 cents on the dollar.
Let us consider which foreign debt crisis this is. Considering Latin America alone, it is the fourth.
The first was in 1825, as the Latin American countries defaulted on the heavy borrowings of their first generation of independence. There was another round of defaults in the 1870s and another in 1929 and the early 1930s. This is a 50-year cycle we seem unable to avoid.
The parallels are remarkably clear in Max Winkler's "Foreign Bonds, An Autopsy," written in 1933:
"During the years 1924 to 1929, Great Britain and the United States made loans to South America. As a result, boom conditions prevailed: Railways were built and public enterprises carried out, imports were greatly increased, wages and prices were raised.
"In 1929 and 1930, when the steady flow of credit was cut off, the burden of debts and accrued interest became much greater than was originally intended. It is not surprising that a number of countries have found it impossible to repay their obligations."
"The fiscal history of Latin America is replete with instances of governmental defaults. Borrowing and default follow each other with regularity. When payment is resumed, the past is easily forgotten and a new borrowing orgy ensues. This process started at the beginning of the past century and has continued down to the present day. It has taught us nothing."
It had still taught us nothing by 1980.
We may conclude that historical understanding is required for sufficient balance and perspective in debates about restructuring the banking system. Also we may desire frequent reminding of what Walter Bagehot knew in 1873:
"You can afford to run much less risk in banking than in commerce, and you must take much greater precautions. Adventure is the life of commerce, but caution is the life of banking."
But the essential lesson is the need for education in the history, the experience, and the intellectual debates of the banking trade for young banking officers - not to mention for central bankers and regulators.
A breed of bankers well versed in history and theory just might reduce the frequency with which we repeat banking crises.