[su_dropcap style=”flat”]B[/su_dropcap]ANKS IN THE U.S. and the other thirty-three OECD (Organization for Economic Cooperation and Development) countries are similar in most ways to other non-bank businesses. Equity investors (also known as shareholders) own the banks. The creditors to the banks are also typically non-government investors. In theory, just as with ordinary non-bank businesses in capitalist economies, good performance of the banks provides investment returns to both equity and debt investors.
Also in theory, failure of a bank should produce losses to all investors. But this point is the first difference of interest between banks and non-banks. There is a high probability that a national government will “bail out” a failing bank. Such bailouts often protect some creditors from taking any loss. The government will impose losses unpredictably on the equity investors and on some classes of creditors. While it’s possible that a government would rescue a failing non-bank, such bailouts are far less likely than those for banks. The likelihood of government intervention to keep a failing business afloat varies considerably from one country to the next.
Enron and WorldCom declared their bankruptcies in December 2001 and July 2002, respectively. Both events counted as the largest bankruptcies in history at the respective points in time. Yet there was no clamor at all in the U.S. for the government to save the shareholders and creditors of these firms. LyondellBasell Industries, a multi-national chemical company based in the Netherlands, filed the largest bankruptcy of a non-U.S. entity in January 2009. Lyondell received no bailout.
History’s largest bankruptcy is that of Lehman (Lehman Brothers Holdings Inc.) in September 2008. Though apparently an exception to the rule that governments generally bail out banks, Lehman’s filing confirms this general rule indirectly. After Lehman’s default, there was a great deal of political debate within the U.S. as well as sniping commentary from Europe to the effect that the government should have bailed out Lehman. Though the hindsight support for a Lehman bailout was not universal, the existence of controversy was evidence of a significant bailout sentiment.
Other Forms of Government Support
Banks in OECD countries also receive other forms of government support beyond the implied guarantee of bailout. We list these forms of support briefly here and will discuss them at more length in later chapters.
Deposit insurance, as we noted in chapter 3, protects depositors from losses if and when a bank fails. Though this support is direct assistance to the depositor rather than the bank, it is also beneficial to the bank. The bank will receive more deposits than it otherwise would in the absence of the insurance (all else equal).
The Central Bank (CB) of each country provides further government support. Created by legislation in 1913, the modern CB in the U.S. is the Federal Reserve System (also known as “the Fed”). The Fed lends directly (“lender of last resort”) to U.S. banks when such banks have greatest need. The Fed instituted a subsidy (“interest on excess reserves” – IOER) for banks in 2008 to assist and supplement bank earnings. Finally, a primary goal of Fed monetary policy from the year 2008 to the present (2016) has been to support banks through low interest rates that push bank asset values higher, reduce bank loan losses, and increase bank income.
One might argue that governments often support non-bank businesses as well. Enacting tariff barriers to imports in a favored industry such as steel or automobiles, for example, is government “support.” The government’s or CB’s deliberate weakening of the national currency is a perennial alleged “support” method for a country’s exporting industries. Yet, on balance, it’s reasonable to conclude that governments provide preferential support to the banking sector.
Regulation is pervasive. All businesses encounter regulation pertaining to hiring and employment practices, workplace safety, privacy protection, and environmental issues. Many, though not all, businesses face product safety and efficacy rules, disclosure and fair dealing requirements, securities laws, and other stipulations.
Banks and related financial institutions confront a huge additional dimension of scrutiny. An array of regulators – beginning with the national CB but also including other agencies of government at national and local levels – analyzes in detail the operations and asset risks of banks. It is not an exaggeration to say that regulators impose the risk management framework of the banking system.
Calomiris and Haber analyze banking structure and operations over the past centuries and across varying countries and types of government. These authors argue that “political bargains” in all cases determine banking structure and operations. The bargains differ substantially depending on whether the form of government is authoritarian or democratic. Within democratic societies, the degree of populism (“majority rule”) versus liberalism (protection of individual, corporate, and property rights from majority rule) also plays a large role in the bargain that underlies the banking system.
In the landscape of Calomiris and Haber, governments need banks as agents for sovereign borrowing. Thus, governments charter banks to enable and expand such borrowing and also to accomplish political tasks of providing loans to favored sectors and individuals. In return, governments confer limited “charters” such that banks with charters have reduced competition and therefore enjoy higher returns than they would receive in an open market. Direct and indirect government support of banks, including bailouts, are just additional features of the “bargain.”
This Calomiris-Haber worldview is entirely consistent with the history we provide in chapter 8 for Central Banks. Specifically, Sweden and Great Britain formed the world’s two oldest Central Banks with explicit intent that these banks would serve as sources of sovereign funding. In the modern U.S. era, large financial institutions act as “primary dealers” in selling, buying, and trading the debt of the U.S. government. Governments expect that Central Banks and other banks will buy and hold large amounts of sovereign debt – which means that the banks are lending to the government. In the modern Eurozone especially, this arrangement creates a well known “vicious circle” that links credit weakness of a sovereign to credit weakness of the country’s banks.
If we grant that banks and the banking system are agents of government, we may just as well characterize banks as agencies of government. That is, banks differ from non-bank corporate entities in that banks are effectively part of the government. Chapter 9 provides detail of government regulation of banks. Chapter 11 describes government lending, guarantees, and bailouts of banks. Regulation is control while loans and guarantees are investments. Combining these elements of control and investment with the government’s reliance on banks to buy sovereign debt and lend to constituencies that the government deems beneficial to the economy, banks are de facto government agencies. Quoting Calomiris-Haber:
“Chartered banks are always the outcomes of political partnerships that include both the government and the coalition of citizens that wins control over shaping the banking system. The state depends on banks as a source of revenue, lending, and other financial assistance.”
At risk of redundancy, Calomiris and Haber also write:
“One of the major themes of this book is that chartered banks represent a partnership between the parties in control of the government and the founders and shareholders of the banks.”
Calomiris and Haber voice the perspective of a careful academic review of history. Let’s consider as well the practical vantage point of the CEO of a large U.S. bank:
“In theory, CEOs report to boards, who then report to shareholders. While that’s true of most businesses, in the financial services industry, we only quasi-report to boards, quasi-report to shareholders, and definitely report to regulators.”
The guarantee-control-agency relationship of large banks to the U.S. government is similar to the pre-2008 relationships between the government and the two U.S. enterprises (i) Federal National Mortgage Association (“Fannie Mae” or FNMA) and (ii) Federal Home Loan Mortgage Corporation (“Freddie Mac” or FHLMC). Thus, we claim that the story of Fannie Mae and Freddie Mac supports the view that large banks are agencies of government.
Legislation of the 1930’s through the 1980’s first created Fannie Mae and Freddie Mac as government agencies and later privatized them so that they nominally became separate from the government. As private entities, Fannie and Freddie had public shareholders and lenders. The U.S. government provided no direct guarantees (such as deposit insurance for banks) or loans. Yet the public markets generally believed the government would bail out Fannie and Freddie creditors in times of crisis despite the absence of explicit guarantees. The U.S. Treasury confirmed this belief in September 2008 when it seized Fannie and Freddie and bailed out the creditors. Ultimate losses to the U.S. taxpayers will exceed $150 billion. In effect, Fannie Mae and Freddie Mac had always remained part of the government.
The next excerpts for Chapter 4 will discuss “Government Enforcement of Legal Contracts,” “High Leverage” and “Short-Term Funding”
 See the excellent and authoritative Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner Report, published in 2010.
 See, for example, J. Warner, “How the collapse of Lehman Brothers averted a second depression,” The Telegraph, September 11, 2009.
 C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014.
 We note that Patrick Spread created the theory of “support bargaining” in the economics realm which holds “political bargaining” as a subset. Spread’s published books include: A Theory of Support and Money Bargaining, Macmillan, 1984; Getting it Right: Economics and the Security of Support, Book Guild, 2004; and Support-Bargaining: The Mechanics of Democracy Revealed, Book Guild, 2008.
 Calomiris and Haber often employ the term “the Game of Bank Bargains” in C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014.
 See, for example, J. Brunsden and J. Carlstrom, “EU Banks’ Debt Addiction Threatens ECB-Led Overhaul,” Bloomberg News, February 10, 2014.
 See the conclusion of chapter 14 of C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014.
 Id. at chapter 9.
 For a brief history, see N. E. Weiss, “Fannie Mae’s and Freddie Mac’s Financial Status: Frequently Asked Questions,” Congressional Research Service, R42760, August 2013. Chapter 7 of C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014, also discusses Fannie Mae and Freddie Mac in the context of U.S. residential lending as does G. Morgenson and J. Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, Time Books, 2011.
 See, for example, A. Blumberg, “Self-Fulfilling Prophecy: The Bailout of Fannie and Freddie,” National Public Radio, March 29, 2011.
 See, for example, “FHFA as Conservator of Fannie Mae and Freddie Mac,” Federal Housing Finance Agency.
 N. E. Weiss, “Fannie Mae’s and Freddie Mac’s Financial Status: Frequently Asked Questions,” Congressional Research Service, R42760, August 2013.