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The Problem with Banks

The Problem with Banks

by Lena Rethel, Timothy J. Sinclair

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Banks of all sorts are troubled institutions. The cost of public bail-outs associated with the subprime crisis in the United States alone may be as high as US$5 trillion. What is the problem with banks? Why do they seem to be at the centre of economic and financial turmoil down through the ages? In this provocative and timely book, Rethel and Sinclair seek answers to


Banks of all sorts are troubled institutions. The cost of public bail-outs associated with the subprime crisis in the United States alone may be as high as US$5 trillion. What is the problem with banks? Why do they seem to be at the centre of economic and financial turmoil down through the ages? In this provocative and timely book, Rethel and Sinclair seek answers to these questions, arguing that banks suffer from perennial problems, and that developments in the financial markets and government in recent decades have simply exacerbated these issues. The book examines banking activity in America, Asia and Europe, and how specific historical circumstances have transformed banks' behaviour and attitude to risk. While many see government as a constraint on banks, Sinclair and Rethel argue that what governments do in terms of regulation shapes banks and their motivations, as can be seen in the shortcomings of current reform proposals. Instead, more far-reaching, alternative ways of regulating and shaping banks are needed. A concise, essential overview of a pressing global issue.

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The Problem with Banks

By Lena Rethel, Timothy J. Sinclair

Zed Books Ltd

Copyright © 2012 Lena Rethel and Timothy J. Sinclair
All rights reserved.
ISBN: 978-1-84813-941-1



Banks of all sorts are troubled institutions. The cost of public bailouts associated with the subprime crisis in the United States alone may be as high as US$ 5 trillion. What is the problem with banks? Why do they seem to be at the centre of economic and financial turmoil down through the ages? And was there anything different about the most recent banking crisis? These are the central questions this book seeks to answer. Although there is of course an established literature on banking, this largely focuses on the financial operations of banks considered in abstract process terms. Banks are conceptualized as institutions that have emerged to fulfil certain functions in society (e.g. to safeguard deposits and to intermediate between savers and borrowers). Thus, their operations are thought to follow a rather timeless functionalist logic. This volume, however, considers banks in terms of the specific historical circumstances they face, and how these circumstances have changed the identity of banks from market authorities to market participants, transforming their behaviour and appetite for risk. We think there is a lack of appreciation of how government shapes what banks do, and how they evolve as institutions. Again, most of the expert literature merely sees government as a constraint on banks. We argue that what governments do in terms of regulation shapes banks and their very motivations. In order to understand banks one must understand their link with states and how this has changed over time.

Importantly, given the recent global financial crisis, we intend to discuss new and alternative ways of regulating and shaping banks that go beyond simply putting into place new rules of conduct that banks will do their utmost to avoid. However, before we do so in the subsequent chapters of this book, let us first consider the crisis-prone nature of banks over time and across regions and jurisdictions and the public responses that it has drawn. The following discussion looks at both how banking crises have led to more regulation, but also at how this in turn has systematically influenced the evolution of banks. It pays particular attention to the key argument that we propose, namely that governments have played a pivotal role in shaping how banks have evolved over the centuries and that this has to be taken into account when it comes to creating space for any meaningful discussion of banking reform.

Regulating Banks

In 2008, at the height of the global credit crunch, pundits warned that the world was about to see 'the mother of all bank runs' (Roubini 2008). However, the capitalist world has been marred by bank runs and banking crises for centuries. Indeed, it is perhaps one of the more positive effects of this – and previous – financial crises that they have spurred a wave of literature that attempts to put financial crises in historical perspective (see e.g. Reinhart and Rogoff 2009; Kindleberger 2000). What we can learn from this literature is that – more often than not – banks have been at the centre of financial crises. Banks have been both deeply implicated in their emergence and also strongly vulnerable to their occurrence.

This fate has been shared by developed and developing countries alike. As Reinhart and Rogoff (2009: 141) put it,

Although many now-advanced economies have graduated from a history of serial default on sovereign debt or very high inflation, so far graduation from banking crises has proven elusive ... banking crises have long impacted rich and poor countries alike.

If there is a difference between countries, it seems that international financial centres are more prone to banking crises. Indeed, if we look at the experience of the last 100 years, the USA with its deep and sophisticated financial system has suffered more heavily from financial crises than any other country. Economic development on its own certainly is not sufficient as a cure against banking crises.

What is the problem with banks? Why is their history marred with crises and yet why have they – despite their seemingly troublesome nature – come to play such an important role in everyday economic and political life? To answer this question, it is important to take a closer look at the historical evolution of banks and their relationship with states. Indeed, the enduring existence of banks would have been impossible without the constitutive role played by states and government regulation. Over the centuries, crises have played a pivotal role in this development (Grossman 2010; Banner 1998).

Banks are not an invention of the capitalist era. The existence of institutions fulfilling a safekeeping function, one of the major tasks of banks, dates back several millennia. Indeed, in the ancient world, temples in Egypt and Mesopotamia were solidly constructed and often considered refuges, so served the safekeeping function (Hoggson 1926). However, modern forms of banking are usually traced back to developments in the city states of late medieval/early Renaissance Italy such as Genoa and Florence (Hildreth 2001). There exists a close relationship between the emergence of states as modern forms of political community and the lending activities of bankers (Tilly 1992; Kindleberger 1993). Thus, the very political nature of banks from their origins should not be underestimated. Banks, such as that owned by the Rothschilds, extended loans to finance the military activities of kings, including England's campaigns in the Napoleonic wars. Nevertheless, with the growing importance of fractional reserve banking, where only a relatively small proportion of a bank's demand deposits are actually held as readily available reserves, the frequency of banking crises increased dramatically. And so did the complexity of state–bank interaction as states increasingly strove to regulate the conduct of banks. In the following discussion, we first look at motivations to regulate banks more generally, before turning to more recent efforts to coordinate the regulation of banks on an international level and how this again has contributed to changes in the nature and quality of banking regulation and operations.

Ad hoc efforts to support bank-like financial institutions vis-à-vis financial instability can be traced back over millennia. Thus, in Davis's (1910) humorous account of the business panic of 33 AD, where lenders were threatened by a loss of confidence caused by a series of alleged and real business failures, the spread of financial instability, complete with a series of runs on lending institutions, was only halted when the Emperor Tiberius stepped in as lender of last resort. Historically in Europe, the emergence of modern banking practice was strongly linked to a series of banking and financial crises such as the South Sea and Mississippi crises of early-eighteenth-century Britain and France. In striking similarity to the recent global financial crisis, both crises revolved around a bank-driven monetary expansion, generated by Sword Blade bank in England and John Law's bank in France. Other companies sprang up to take advantage of the speculative fever, including one formed 'for carrying on an undertaking of great advantage, but nobody to know what it is' (Galbraith 1993: 49; Kindleberger and Aliber 2005: 165). The nineteenth century, often praised as an era of relative international monetary stability, bore witness to a range of banking and financial crises, but also laid the foundations for more elaborate approaches towards the public regulation of banks.

Initially there was little difference or even separation between the private and the public spheres in banking (Grossman 2010; Kindleberger 1993). More specifically, central banking as a distinct regulatory practice only arrived relatively late in the history of banks, as the chequered history of the Bank of England, incorporated in 1694 by royal charter as a private company, illustrates. While the state had to develop the tools necessary to regulate banks and to intervene in financial markets, the onset of the industrial age brought massive growth in the banking industry. This was accompanied by increasingly frequent banking crises that at the time mainly hit the more developed countries that had more advanced banking systems (see also Figure 2.1). Indeed, Reinhart and Rogoff (2008: 13) suggest that in particular France, the United Kingdom and the United States stand out in this respect, having been hit by a banking crisis 15, 12 and 13 times respectively since 1800.

Like Europe, the United States has not been spared banking crises. Indeed, in 1792, shortly after gaining independence, the nascent nation was hit by a financial crisis caused by speculation in the stock of the Bank of New York, with rival parties trying to cause the stock to rise and fall, precipitating a bank run. Treasury Secretary Alexander Hamilton stemmed the crisis by intervening in the banking system (Sylla et al. 2009). A more dramatic wave of financial panic and bank failures swept the United States in 1818–19. Ever since then, the USA has suffered from periodic outbreaks of more and less severe banking crises and bank failures, with the panic of 1907, the financial crisis during the Great Depression of the 1930s, the savings and loan crisis of the late 1980s and early 1990s, and the subprime crisis of the late 2000s being the most dramatic.

The 1907 financial panic came about after the failure of a trust company at the centre of Wall Street speculation (Bruner and Carr 2007). Calamity was avoided by cooperation between major banks, led by J.P. Morgan, the world's best-known and most powerful banker. Again, the American government initially relied largely on ad hoc mechanisms, before moving towards a more systematic response to banking crises. Thus, a massive effort to (better) regulate banks was undertaken as a response to the 1930s' crisis when the American banking system suffered heavily during the economic turmoil of the interwar period. All in all, about 9,000 banks, a third of all banks in the United States, had to be closed during the period from 1929 to 1933 (Galbraith 1977: 202). As is well known, the American government reacted by introducing a range of far-reaching banking reforms.

The 1933 Banking Act (also known as the Glass–Steagall Act) compelled the splitting up of banks according to the type of business they were undertaking (commercial or investment banking). It also introduced a system of deposit insurance and limits on the interest that could be charged by banks. However, it has to be noted that this segmentation of the banking market was built on trajectories within the American regulatory system that can be traced back at least to the Civil War (White 1982).

In the post-World War II period, the segmented banking system increasingly came under challenge as the economic centre of gravity moved to the USA. The regulatory efforts of the 1930s failed to make the US financial system crisis proof. A series of bank failures in the 1970s and the resurgence of free-market ideas triggered a spate of deregulatory efforts that increasingly undermined the provisions of the 1933 Banking Act. Along these lines, from the 1990s onwards, there was a decisive move away from the segmented market model and towards a more European-style universal banking model in the United States as commercial banks (deposit-taking institutions with retail and wholesale operations) sought to operate in the capital markets. This was compounded by the eventual repeal of the 1933 Banking Act in favour of the Financial Modernization Act (also known as the Gramm–Leach–Bliley Act) in 1999 (Crockett et al. 2003). Recent efforts to reregulate the American banking system in the wake of the subprime financial crisis have to be seen against this backdrop.

East Asia, although less visible in mainstream discourses on banking crises and regulation, also suffered its fair share of banking instability and crises, even prior to concerns about the effectiveness of local banks during the Asian financial crisis of 1997–98 (see e.g. Hill 2003 and other contributions in this special issue). During the colonial period, Western merchant banks brought modern banking practices to the region (Ji 2003; Cheng 2003). Their claims to extraterritoriality put them outside the control of local authorities. Indirectly this already foreshadowed some of the problems with the supervision and regulation of transnational banking groups. In recent times, the most dramatic such occurrence was the collapse of Barings following wild speculation by one of its Singapore-based employees in the mid-1990s. The incident exposed gaps in the international supervisory framework and problems with the coordination of home country (UK)/host country (Singapore) supervision (Herring 2005).

Long before then, and exacerbated by the arrival of modern banks and banking operations, local financial institutions also exhibited vulnerabilities and repeatedly succumbed to crisis. China suffered from financial instability and banking crises in the late nineteenth and early twentieth centuries, such as the Shanghai rubber stock-market crisis of 1910, where speculation in rubber stocks turned awry, resulting in the closure of domestic banks (Ji 2003: 93). Japan's 1927 banking crisis affected its colonial dependency, Taiwan. State-building and the promotion of modern practices of banking were closely linked in the region. This is well illustrated by the diverse crisis experiences in the banking systems of Southeast Asia (Cook 2008; Hamilton-Hart 2002; Singh 1984: 271).

Banking troubles again lay at the heart of Japan's lost decade of the 1990s and also spread from Japan to the wider East Asia region in the 1997–98 financial crisis (Amyx 2004; King 2001). The Asian financial crisis demonstrated how interlinked national financial sectors had become and how bank instabilities in one country could rapidly spill over into other jurisdictions. It also exposed the vulnerabilities that were created when highly politicized banking sectors met with the vagaries of disintermediated international portfolio investment flows (Haggard 2000). As a consequence of the crisis and the challenges that it was seen to have posed to 'business as usual', Asian policymakers felt increasingly compelled to implement financial sector reforms and, at least to some extent, to adopt international best practices (Walter 2008).

While this account of the history of banks and their evolution in Europe, the United States and East Asia is by necessity broad-brushed, it nevertheless highlights the fact that banks around the globe are very crisis-prone institutions. This has served as a major justification for states to devise rules for the conduct of banks. The emergence of modern states and modern banking systems has been closely intertwined. Whereas for a long time banks had had to deal with defaulting sovereigns, now states came increasingly to incur the costs of defaulting banks. States had to develop the tools to move from ad hoc interventionism to more formal mechanisms of bank regulation. Yet, in the process, responses to banking crises also fundamentally shaped the boundaries for future financial arrangements. In so doing, they did not just constrain but indeed created the behaviour of banks, thus setting in train pathologies for future crises.

Mainstream accounts of banking regulation identify a range of reasons for governments to regulate banks. According to Kroszner (1998), these can be divided into two broad categories: those that focus on the orderly provision of banking services, in particular to prevent conflicts of interest and establish the fairness of transactions, and those related to financial stability considerations. Explanations falling in the first category draw attention to the important role that banks play as economic actors and their traditional functions such as mobilizing savings, intermediating between borrowers and savers, and monitoring and disciplining borrowers on behalf of savers. Yet banks as profit-maximizing organizations are more than neutral go-betweens (Palazzo and Rethel 2008: 195). Thus, banks are prone to conflicts of interest that are deemed to distract or prevent them from fulfilling their economic role in an efficient manner (Kroszner 1998; Crockett et al. 2003). According to this view, governments (have to) step in as regulators to correct market imperfections.

We suggest that the conventional view that focuses on banks as economic actors, operating in a somewhat distinct economic sphere, pays too little attention to their role as social and political actors and thus underplays their systemic significance. It offers only an incomplete portrait of what they do. Thus, banks and their regulation should not be conceived in largely abstract process terms but linked to wider political and social developments. An important such development over the last century has been the expansion of the democratic franchise. However, when it comes to bank regulation, democratic expansion puts pressure on governments to protect the savings of voters, as well as their tax payments (Rosas 2009; Thirkell-White 2009). In this regard, an important driver of regulation/public policy highlighted by the discourses surrounding the recent global financial crisis is to avoid the costs of future bailouts, given the perceived necessity for governments to step in as lenders of last resort to prevent systemic financial crises. Reinhart and Rogoff (2009: 142) suggest that focusing on the costs of bailouts associated with banking crises presents us with only part of the picture. The implications for tax revenue and public debt are far more significant. According to their calculations, modern banking crises have resulted in an average increase of real government debt by 86 per cent during the three years following the crisis. This order of magnitude applies equally for developed and developing countries.


Excerpted from The Problem with Banks by Lena Rethel, Timothy J. Sinclair. Copyright © 2012 Lena Rethel and Timothy J. Sinclair. Excerpted by permission of Zed Books Ltd.
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Meet the Author

Lena Rethel is Associate Professor of International Political Economy at the University of Warwick. Timothy J. Sinclair is Associate Professor of International Political Economy at the University of Warwick.

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