Two Books That Will Enrich Your Understanding of Banking and Bank Crises
Over the summer, I had the pleasure of reading the prerelease versions of two books about banking and financial crises: Finance and Philosophy: Why We’re Always Surprised, by Alex J. Pollock, (Paul Dry Books, October 16, 2018), and Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi, by James Freeman and Vern McKinley (Harper Business, 2018). Pollock’s book is being released in October, and Freeman and McKinley’s book is already available. If the history of banking and financial crises interests you, I think you will find both books to be rich in content and enjoyable to read. I know I did.
In Finance and Philosophy Alex Pollock, a former president and CEO of the Federal Home Loan Bank of Chicago, applies his formidable intellect and a lifetime of banking experience to explain in a simple and entertaining way why we continue to have banking crises and why post-crisis regulatory reforms are doomed to fail.
Banking systems will be prone to crises so long as investors confuse risk and uncertainty writes Pollock. Risk can be modeled, assessed and managed, but not so uncertainty.
Risk assessment is the process of attaching odds to possible outcomes by analyzing data. For example, what is the probability of getting “heads” if you spin a penny? Spin the penny enough times, and you can accurately estimate this probability (it is not ½) from the sample data. Uncertainty arises when outcomes cannot be predicted based on past experience. Outcomes that appear to be impossible based on past experience may turn out to be merely improbable.
As memories of past crises fade, investors abandon skepticism and place increasing confidence in heuristic models of risk. Because risk models focus on regularities, they ignore uncertainty. When financial markets are impacted by uncertainty, risk models break down, and investors suffer losses that they never thought possible. If the unanticipated losses are large enough, investors withdraw wholesale from markets, and crisis ensues.
Pollock recounts numerous historical examples where the accuracy of heuristic models evaporated once investors and regulators adopted models to guide their actions. For example, in the recent financial crisis, institutions relied on models to parse the risk in subprime mortgage-backed securities. To describe the impact of uncertainty, Pollock quotes Tony Saunders “[t]he rocket scientists built a missile which landed on themselves.”
In Pollock’s view, over confidence in heuristic models is especially problematic when models are sanctioned by bank regulators or the Federal Reserve. For example, time and again, investors have been crushed when uncertainty reveals that investments like government bonds—presumed to be “riskless” in regulatory models— aren’t. Or markets presumed to be deep and dependably liquid—like commercial paper—cease to function.
The confusion between risk and uncertainty is not limited to private bankers and investors—in Pollock’s view, it is endemic among the modern central bankers entrusted with managing the economy. Unable to anticipate economic uncertainty, their economic models often misinterpret the economic tea leaves and lead central bankers (Pollock’s would-be “philosopher kings”) to adopt policies that magnify financial instability as they did in the great inflation of the 1970s and the great moderation (a.k.a. the housing bubble) more recently.
Pollock’s observations and historical examples are compelling, and his wide-ranging discussion of banking and financial crises is not only accessible, but a pleasure to read.
In Borrowed Time, James Freeman and Vern McKinley recount the ups and down of Citibank from its founding days to the depth of the recent financial crisis. Most banks can fail only once. Citibank is unique among large US banks because it likely would have failed multiple times if the Federal government, the Federal Reserve, or the Federal Deposit Insurance Corporation had not intervened to keep the bank alive.
While Citibank has changed its name many times over the years, it has been in business almost as long as the United States has been a sovereign country. James Freeman and Vern McKinley do an admirable job of recounting the evolution of Citibank, its leadership, its business strategies, and its performance. Over a 200-plus year history, the bank has been led by men of outsized influence in both financial circles and the halls of government. Each of Citibank’s leaders has had a unique approach to banking that influenced the development of the entire US financial system.
Over its rich history, Citibank has faced and survived nearly every US financial crisis. Some of Citibank’s early leaders focused on the bank’s financial strength above all else. When crisis erupted, these leaders had Citi in such a strong financial condition that the bank provided emergency credit to the Federal government. Subsequent Citibank leaders focused on shareholder returns and growth, expanding into the domestic securities industry and into banking markets abroad. Citi’s strategy of expanding into the securities business left Citibank open to scapegoating as politicians blamed the bank’s combination of investment and commercial banking for causing the 1929 stock market crash and subsequent depression. Later, Citi’s focus on international growth and shareholder returns left the bank so financially weak, that when crises struck, the bank required emergency government assistance to survive.
Throughout its life span, Citibank has been closely tied to the Federal government. When Citibank was not providing presidents with their Secretary of the Treasury or other senior Treasury officials, Citibank presidents were drafting the laws that created the Federal Reserve System. The history of Citibank, its outsized government influence, its fall from grace in the 1930s, its international expansion and Federal Reserve and US Treasury rescue in the 1980s, and its near-death experience in the subprime mortgage crisis make for a riveting read.
The Citibank story mirrors the development of the US financial system and James Freeman and Vern McKinley do a superb job of recounting the bank’s role in the many financial crises that have marred US financial history. Of the many lessons that can be learned from Citibank’s history, one is that throughout history the government has always been willing to support a large politically-connected distressed bank. If George Santayana is correct, and those that fail to remember the past are doomed to repeat it, investors, economists, and government officials should not miss the opportunity to read Borrowed Time.
