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Death of a Middleman: The Banking Crisis and the Role of the Securities Markets in Comparative Historical Perspective

Death of a Middleman: The Banking Crisis and the Role of the Securities Markets in Comparative Historical Perspective



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Published by Oren Litwin
The American banking sector has been slowly dying for the last few decades, unable to compete with the strengthening capital markets—and this paper argues that we should stop propping up the corpse and let it finally molder away.
The American banking sector has been slowly dying for the last few decades, unable to compete with the strengthening capital markets—and this paper argues that we should stop propping up the corpse and let it finally molder away.

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Published by: Oren Litwin on Jul 16, 2009
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Death of a Middleman: The Banking Crisis and the Role of the Securities Markets inComparative Historical Perspective
Oren Litwin
15 July 2009
As the financial crisis unfolds, interested parties from all sides of the political spectrum have been quick to assign blame. To some (for example Krugman [2009]), the banking crisis wascaused by deregulation and the fruits of unrestrained capitalism. To others, the crisis was set off  by government incentives for risky behavior by mortgage lenders, particularly through assetsecuritization by Fannie Mae and Freddie Mac. While each of these explanations is partly true, both miss the larger structural reasons that led to the conditions the two sides decry. This paper hopes to remedy this lack by employing a comparative approach. The history of the American banking system, which at present is tightly intertwined with the securities markets, will becompared to that of Germany, which has a reputation for excessive control by banks and weak securities markets. Surprisingly, neither of these two characterizations used to be true—and thehistory of how each system changed over time illuminates the roots of the modern crisis, andwhere to go from here. Briefly, the American banking sector has been slowly dying for the lastfew decades, unable to compete with the strengthening capital markets—and this paper arguesthat we should stop propping up the corpse and let it finally molder away.This paper argues that the financial systems of the United States and Germany diverged intheir logic because of the effect of bank regulations on the availability of capital to industry. InGermany, a banking environment with relatively few legal restrictions allowed for rapidindustrial growth by granting easy access to capital—not least through the Berlin securitiesexchange, among the best in the world—despite Germany’s status as a late developer. TheUnited States, despite having built an advanced banking system fifty years earlier thanGermany’s, ran up to limits on growth in the second half of the 1800s due to the
unit banking 
 system, which made the banking system more fragile and limited banks’ ability to providecapital, stifling the development of large-scale industry. United States securities markets alsodeveloped more slowly as a result. Perversely, this resulted in powerful banks gaining
 control over the American economy than would have happened otherwise.The trajectories of both systems were radically altered in the 1930s. In Germany, the Nazisdeliberately throttled the securities markets as part of their campaign against finance capitalism;after the war, the German economy was dominated by direct lending relationships with powerful banks as a result, while the securities markets languished. In the United States, a federalgovernment hostile to the great power of the banks passed a series of laws to curb their power,starting with the 1933 Glass-Steagall Act which divorced investment banking from commercial
This article is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 UnitedStates License, described here:http://creativecommons.org/licenses/by-nc-nd/3.0/us/
 banking. After an initial period of capital scarcity and accompanying economic stagnation, thishad the effect of supercharging the development of the securities markets, as specializedinvestment banks had strong incentives to foster financial innovation in securities. Interest-ratecontrols enacted in 1966 accelerated this process and caused the banks to lose business tomoney-market mutual funds and other direct investments. The competitive pressure caused largecommercial banks to take greater and greater isks to maintain profits and to circumvent Glass-Steagall restrictions, culminating in the passage of the Gramm-Leach-Bliley Act of 1999(GLBA), which repealed the provisions of Glass-Steagall preventing commercial banks from participating in investment banking. Ultimately, however, banks are becoming increasinglyobsolete, and the damage caused to the financial system by their behavior is only made worse by protective subsidies and preferential regulation by the government and the Federal Reserve.
This paper takes inspiration from Hall and Soskice’s (2001) theory of 
institutional complementarities
. The authors argue that specific types of economic institutions will becomemutually reinforcing and lead to very different patterns of behavior.
 Liberal market economies
 will tend to encourage interaction between firms based on supply and demand, and arm’s-lengthtransactions.
Coordinated market economies
, on the other hand, encourage interaction based onstrategic bargaining and large-scale coordination between actors. While these are ideal types and both styles of behavior can be found in any economy, the tone will be predominantly set by oneof these logics. “In any national economy, firms will gravitate toward the mode of coordinationfor which there is institutional support” (Hall/Soskice 2001:9; cf. Baliga/Polak 2004, Monnet/Quintin 2007). In particular, access to capital in a liberal market economy is granted most oftenthrough the capital markets; in coordinated market economies, capital is accessed via long-termrelationships with powerful banks (Hall/Soskice 2001:28). The United States is considered the
ne plus ultra
of liberal economies, while Germany is a good example of a coordinated economy.A given pattern of institutions constrains future development of the system, by making somechanges more attractive than others in the short-term—even when other changes might have better effects in the long-term (North 1990:7). Institutions will also guide the behavior of actorsoperating within them, by encouraging particular kinds of behavior, skills, and learning over other kinds (North 1990:74). Consequently, the constellation of actors and institutions willconstrain each other’s development over time, causing the system as a whole to move accordingto an inherent logic guided by past history (North 1990:99). This is often called
. Path-dependency effects are immensely powerful in the financial industry, in particular when considering the interaction between two components: the banking sector and thesecurities markets.Firms trying to raise capital from investors
need two related things:
.Investors must be able to tell whether a given firm is a good investment; additionally, they must
Firms have two means of raising capital:
. Borrowing money, either in a straight loan from a bank or by issuing bonds, imposes a fixed payment obligation on the firm. Issuing equity, i.e. stock, carries no fixedobligations, but rather a proportional claim on the profits of the firm. Equity is thus riskier but potentially morelucrative for investors.
have some assurances that the firm will stay a good investment, and that managers will notsuddenly adopt risky practices once they can use other people’s money. Banks solve both problems by extracting information from firms and exerting control over behavior through thethreat of withholding future credit. The public capital markets, on the other hand, are less able tomonitor firms and exert control than are banks. Thus, the markets will tend to only fundcompanies that they trust (Calomiris 1995).In general, high-quality borrowers will raise capital in the financial markets, while lower-quality borrowers will turn to bank lending (Macey/Miller 1995). Whether a given firm will beconsidered high- or low-quality depends heavily on the relative sophistication of the bankingsector and the financial markets. The better the markets, the easier for firms to get fundingthrough them (Boot/Thakor 2004). This means that the banking sector tends to lose monopoly power as the markets reduce transaction costs, becomes more transparent, and developsinstitutional responses that allow it to exert control over firms.The foregoing stylized discussion assumed a dichotomy between the stock market and banks.In fact, there are different kinds of banks and different banking systems. A bank that engages inlending is called a
commercial bank 
. An
investment bank 
, on the other hand, provides services tofirms seeking capital on the securities markets; investment bank fortunes are tied to the markets,and not to lending.A bank that does both is called a
universal bank 
. A bank might want to help a firm issuesecurities, instead of lending money directly, in order to expand its client base and not to tie upits own capital in a limited number of firms. Additionally, the fees for 
(facilitatingand marketing) a securities issue can be quite high, partly compensating for lost lending business.In environments of low information and high transaction costs, universal banks can fill aninvaluable role. A universal bank can establish long-term lending relationships with new firms,giving them access to capital in exchange for a large degree of control over their activities.Ideally, as a firm become more seasoned, the bank can help shepherd it up the “financial pecking-order” of funding sources, moving from bank loans, to venture capital, to bonds, tostock (each requiring more trust from investors), taking advantage of its lengthening track record, visibility to investors, and the credibility of the sponsoring bank. Ultimately, the firm willgraduate to relying heavily on the capital markets, using banks for short-term credit and as expertadvisors in navigating the financial world (Calomiris 1995; cf. Fama 1985). This sequencedepends on the quality of the financial markets—if the markets are sluggish, firms will be forcedto rely more on banks for capital.Universal banks will be less likely to foster the development of the capital markets and theinnovation of new financial products, all else equal, because the additional profit they receive isoffset by cannibalized lending business. Furthermore, such innovations are soon adopted bycompetitors, reducing the potential gains if the banking system features heavy competition.Specialized investment banks, on the other hand, are far more likely to innovate because theyhave no lending business to sacrifice. And as the markets grow more sophisticated, they allowthe creation of new products that are even more sophisticated. The reciprocal development of themarkets and financial products conditions future innovation, in a classic example of a form of  path dependency called
increasing returns
(Boot/Thakor 2004).

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