Unsettled Account: The Evolution of Banking in the Industrialized World since 1800

Published by EH.Net (March 2011)

Richard S. Grossman, Unsettled Account: The Evolution of Banking in the Industrialized World since 1800. Princeton, NJ: Princeton University Press, 2010. xx +384 pp. $39.50 (cloth), ISBN: 978-0-691-13905-0.

Reviewed for EH.Net by Eugene White, Department of Economics, Rutgers University.

Another history of banking?? Isn?t the shelf crowded enough? Not quite. While there are thoughtful and not-so-thoughtful books that attempt to explain the origins of the current crisis, Unsettled Account provides us with a new and welcome history of the last three centuries of banking.?

Who should read this book?? A lot of people.? For the legions of political, social and cultural historians, if they have to read one book on the historical evolution of banking, this is it.? It will provide them with the needed theoretical background without an equation in sight, useful country studies, and the insights needed to instruct their students.? For the legions of economic theorists, if they have to read one book on the historical evolution of banking, this is it.? The book is a guide to every key stylized fact they might use for a model, identifying the broad parameters of institutions and history.? For the legions of policy makers, if they have to read one book on the historical evolution of banking, this is it.? Distanced from the crisis of the moment, Grossman nicely hits the key issues and distills some relevant lessons.? What about the specialists, those of us who also write financial history?? Well, we have a worthy successor to older histories of world banking — a subject so large that recent scholars have shied away from attempting a new synthesis.? The last comprehensive history is H. Parker Willis and B. H. Beckhart?s now ancient Foreign Banking Systems (1929). For us, Grossman has sifted through the vast literature (his bibliography is 55 pages) and produced a new and balanced synthesis.?

Given the vastness of the subject, Grossman must be selective and he will not please everyone.? Incorporated banks that were the premi?re financial institution (with important exceptions like the Rothschilds) from the late seventeenth century until the mid-twentieth century have center stage. Investment banks, insurance companies, savings banks, and the multitude of new organizations that grew up in the second half of the twentieth century are set aside.? Furthermore, financial markets that complement and substitute for financial institutions are outside the scope of his inquiry, although he provides a good account of the growth of universal banking.? His focus is on Western banking — with special attention for England, Sweden and the U.S. One might complain that Germany, France, Italy, and Japan should also be case studies, but the overview that Grossman gives us in less than 300 pages requires some hard choices.? Lastly, his focus on the formation of our modern banking systems up to the Great Depression will leave some unsatisfied.

How to approach the seemingly unapproachable topic of banking?? Grossman employs a historical or ?narrative? approach.? As such his book is a logical successor to Charles Kindleberger?s much read and admired books, but while the narrative sufficed for Kindleberger, Grossman guides us by introducing some useful taxonomies to create a structure for analysis.? His comparison of banking systems is arranged according to four key issues: crises, rescues, merger movements and regulation.? It is these elements that combine together to generate the life cycle of the banking industry.

Grossman defines crises occurring when either a very prominent bank or a high proportion of banks are on the brink of failure. These events are enormously costly, sometimes reaching 20 percent of GDP.? While it is generally believed that it is difficult to relate banking crises to fundamentals because of the self-fulfilling character of bank runs, Grossman points to three underlying causes of banking crises: boom-bust cycles, shocks to confidence (often from wars), and weaknesses (usually regulation-induced) in the structure of the banking system.? These three forces, sometimes combined together, enable him to categorize and analyze crises.? He shows that inflation and growth of real GDP were higher during cyclical expansions that were followed by crises, as one would expect in a boom-bust cycle.? For the Great Depression, countries with larger more diversified banks were much less likely to suffer banking crises.? The subprime crisis of 2008-09, which emerged as Grossman was writing his book, serves as an out-of-sample forecast — nicely fitting the story of a boom-bust cycle, exacerbated by regulatory distortions.?

Grossman defines a ?rescue? as ?an intervention by a party not directly involved in a crisis to extend some sort of crisis-averting or crisis-ameliorating assistance to those that are directly involved? (p. 84). His definition is purposely vague in order to encompass the response of bailouts, lender of last resort activity, and ?more extreme measures.? While these actions may reduce the losses suffered by affected financial institutions? stakeholders, their costs are apportioned by political economy.? Lurking behind all such rescues is the danger of moral hazard, potentially inducing worse behavior in the next crisis.? For those who think bailouts are a new phenomenon, the book is an eye-opener, describing rescues of this type in Australia in 1826, Belgium in 1838, and Cologne in 1848.?? Grossman chronicles the development and spread of lender of last resort responses, studying the limitations of the American clearing houses in contrast to the growing effectiveness of the Bank of England.? More extreme actions range from bank holidays and moratoria on payments to nationalizations and deposit insurance.? He analyzes the trade-offs involved in these responses, including the risks of an economic collapse versus moral hazard.

An unmistakable trend over the past 200 years has been consolidation of the banking industry propelled by occasional merger waves. The result may be better diversified banks with economies of scale and scope and increased stability.? Merger movements have been generated by changes in banking technology, general economic growth, and often financial crises when the government invites takeovers of weaker by stronger institutions?? This chapter might also point out the possibility that mergers may have created institutions that are so big that they become ?Too Big to Fail,? increasing their ability to obtain favorable rescue packages from the government.

The dialectic between crisis and regulation makes an analysis of the ills of a banking system particularly difficult.? Crises usually call forth new regulations that may be imposed by a wise government to correct for market failures and improve financial and monetary stability or may be obtained by rent-seeking special interests tilting the playing field in their favor.? Unfortunately, regulations may also sow the seeds of a new disaster.? This problem is amplified by the difficulty of understanding the interactions between various regulations and their consequences.??

Given these complexities, Grossman faces a challenge in describing the evolution of banking?s regulatory attributes and picks out four key types of intervention.? The control of entry first focused on the question of whether one or many banks would have the right of note issue.? Once note issue was monopolized by a central bank, freer entry by competitors was generally permitted, although he finds a pattern where the first countries to centralize note issue were the last to enact a banking code that made entry easy.? His second type of regulation governs capital requirements.? Typically, these regulations initially specified minimum requirements, also limiting entry.? Above these minimums, the market was the key determinant of capital-to-asset ratios for most of the nineteenth and twentieth centuries.? Increased banking sophistication led to a drop in the average ratio for all countries from around 40 percent in the mid-nineteenth century to under 10 percent by 1920. What was the effect of government-imposed capital requirements?? Grossman offers a graph showing that countries without these regulations had higher ratios before 1913 and that haves and have-nots converged after World War I.? Interpreting this is daunting but he posits that more conservative banking systems may not have tempted government regulation.?? The third regulation — whether universal banking should be permitted, is certainly one of the most hotly debated issues today.? Grossman finds that universal banking came into existence without government sanction or encouragement often responding to the pace at which securities markets developed.?? In contrast, its demise in the U.S., Italy, and Belgium during the Great Depression was the result of government response to the alleged contribution of universal banking to the economic collapse — although this remains highly contested.? Who will police or supervise government-imposed rules constitutes his last dimension of regulation.? Sometimes this authority was placed within a central bank and sometimes in one or more independent agencies.?? Grossman finds an intriguing regularity that should stimulate future research: younger central banks were more likely to be made bank supervisors than their older counterparts.? He hypothesizes that this may because younger central banks were more adaptable in their approach to operations and able to manage a dual role.

The next three chapters offer case studies of England, Sweden and the U.S., which Grossman feels exemplify three distinctive evolutions.? For England, it was the fiscal needs of the state that started joint stock banking, creating the Bank of England in 1694 to provide a large loan to the government.? It was rewarded with the privilege of note issue and limits on competition.? By 1826, the needs of finance for the country?s rapid industrialization led to easier entry, temporarily reversed following crises in 1844.? While the Bank of England ultimately obtained a monopoly of note issue, competition came from deposit-creating joint stock banks. At the same time, recurrent crises and? increasing concentration of banking brought the Bank of England to recognize its role as a lender of last resort,?? While it failed to adequately manage the Overend, Guerney crisis in 1866, it quickly handled the Baring failure in 1890, ensuring that it did not lead to a full-scale panic.??

Grossman uses Sweden?s history as a counterpoint to England?s evolution.? In Sweden, joint stock banking arose not from the fiscal needs of the state but from the need for a useful means of exchange — paper money was a vital substitute for the weighty copper coinage.? Easy entry and competition was ultimately ensured because of the struggle between the Diet and the King over control of the banking system. The founding of the Riksbank in 1656 was modeled on the banks of Amsterdam and Hamburg, permitting it to take deposits, effect transfers and make collateralized loans.? Modern banking took off after the repeal of interest rate ceilings and the permission of limited liability in the 1860s.? Following the English pattern, liberalization brought both mergers and instability that led to increased supervision and regulation, particularly after the World War I slump and the collapse of Ivar Kreuger?s industrial empire in 1932.

In contrast to England and Sweden, the U.S. experience was heavily shaped by the federal nature of U.S. government.? Grossman views the origins of U.S. central banking as lying between England and Sweden with the First and Second Banks of the U.S being partly private and partly government owned.? The strictly limited 20-year charters helped to politicize banking and led to the ultimate demise of these proto-central banks.?? But, their rivals, the state-chartered banks did not survive with their privileges intact.? The demand for finance and open entry in democratic Jacksonian America led to the ?free banking? era.? Grossman also highlights as particularly American the early detailed banking codes imposed by the Congress and states.? As is well known, the consequence of these regulations was a fragmented banking system prey to frequent panics with no lender of last resort.? The response, the Federal Reserve Act of 1913, was to create a federal central bank — reflecting the political fears of concentrating power.? Unfortunately, the design of this institution weakened its capacity to act as a lender of last resort at critical moments during the Great Depression.

Grossman?s last chapter leaps through the vastly complicated remainder of the twentieth century.? Across all countries, he sees events as governed by the ?lockdown? during World War II and the slow postwar deregulation that was accelerated by the breakup of the Bretton Woods System.? ?Lockdown? is an apt word for the corset of regulations imposed on banks during the Second World War.? Interest rates, entry, mergers and activities were controlled; yet the anti-competitive nature of these regulatory regimes kept banks profitable, stable, and safe.? However, the growing demand for finance and unexpected inflation guaranteed that these systems could not endure.? The individual character of each national regime produced very different implosions, including the U.S. savings and loan collapse, the Nordic crises and Japan?s prolonged banking disaster.? The regulatory responses, notably Basel I and II, did not enhance stability; and he briefly touches on the crisis of 2008, perhaps saving that for a future historian to place in its proper historical context.? In the end, there are no parting policy recommendations.? Instead, Grossman sees a continuing pas de deux between regulator and regulated.? Regulators will attempt to correct weaknesses in the system after each crisis, while the regulated institutions will struggle to circumvent the constraints that limit their ability to meet the demands for finance.

Eugene N. White is a Professor of Economics at Rutgers University and is currently visiting the Paris School of Economics.? He is co-author (with Andrew Crockett, Trevor Harris and Frederic Mishkin) of Conflicts of Interest in the Financial Services Industry: What Should We Do About Them? (CEPR, 2003).

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