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Broken Government

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Can the 'Disasterous Nexus' of Banks and Governments Be Contolled? No.

October 24th 2013


The president of the Deutsche Bundesbank, Jens Weidmann, discussed in a recent essay, "Stop Encouraging Banks to Load Up on State Debt," what he calls the "disastrous sovereign-banking nexus" — in other words, the disastrous interaction of governments and banks. Governments can reduce their own solvency by bailing out insolvent banks — and can even become themselves insolvent and in need of bailouts by doing so, as in the cases of Ireland, Iceland, and Cyprus. On the other hand, banks can become insolvent by making excessive loans to, or investments in, their own or other governments, which turn out to be financial mistakes, as is exemplified in the European sovereign debt crisis and its ongoing travails.

Loans to sovereign governments are granted favored status by bank regulations and indeed are promoted by them, as having no risk-to-one-borrower limits for example, as well as very low or zero capital requirements, and being often referred to as "risk-free." But in fact nothing is more common in financial history right up to now than defaults by governments on their debt. There have been about 250 defaults on sovereign debt since 1800, including widespread government defaults in the 1980s and the 21st century defaults by Greece and Argentina. Of course, a possible default by the United States government has been talked about of late ad nauseam.

Mr. Weidmann points out the shortcomings of the "preferential treatment of sovereign exposures" by banking rules and calls for it to be reassessed and reduced. He thereby proposes a good and financially sound idea, but an idea that is certain not to happen.

Give a moment's thought to the question: Why do banking regulations always promote having banks invest in government and government-sponsored debt (for a U.S. example of the latter, investing in the debt of failed Fannie Mae and Freddie Mac without limit)? The answer is apparent: the regulators who write the rules are themselves employees of the government. They are hardly likely to limit or criticize banks' lending to their own employer. Indeed the contrary, i.e. promoting the debt of the government and its various sponsored projects through the banking system, is naturally the case. The conflict of interest is obvious.

Such a conflict is unavoidable in a perspective which views banks and governments as mutually dependent enterprises, as intriguingly explored by Charles Calomiris and Stephen Haber in their forthcoming book, Fragile by Design. While considering "why states need banks," they write, "all governments face inherent conflicts of interest when it comes to the operation of the banking system," since "governments simultaneously regulate banks, and look to them as a source of finance."

The evident usefulness of having banks to lend to it is a classic reason for a government to charter banks in the first place. The archetypical case is the establishment of the Bank of England in 1694. The deal was straightforward: the bank got its charter by promising to lend money to the government, much needed to finance King William's wars at the time, and the government would give the bank profitable special privileges, especially a monopoly of issuing currency. (It didn't hurt that the Royal Family was among the shareholders of the new bank.)

In the U.S., up until the National Banking Act (originally the "National Currency Act") in 1863, the states were the predominant governments which chartered banks. They would not uncommonly require purchase of their own state bonds as a condition of granting the charter. State bonds were hardly risk free: the governments of Alabama, Arkansas, Florida, Georgia, Louisiana, Michigan, Minnesota, Mississippi, North Carolina, South Carolina, Tennessee, and Virginia all defaulted at various times-not counting the Confederate bonds which were of course not paid after the Civil War.

During the Civil War, the National Banking Act empowered the national government to charter banks on the same logic as the states had previously used and as the founding deal of the Bank of England. The point was to have the new national banks lend money to the government by buying U.S. Treasury bonds to finance the war. In exchange, they could issue paper currency collateralized by the bonds they bought. Exactly the same logic continues as the structure of the Federal Reserve Banks today.

In the late 20th century, U.S. banking regulators with vast imprudence promoted the unlimited purchase by banks of the obligations, and even the preferred stock, of the government-sponsored Fannie Mae and Freddie Mac. This was to advance a government agenda of expanding mortgage debt on the Treasury's credit, while for appearances, keeping it off budget. In 2008, when Fannie and Freddie failed, U.S. banks owned over $1 trillion of their bonds and mortgage-backed securities, equal to about 116% of the banks' total tangible equity (let alone what foreign banks and governments owned). Imagine what would have happened to the banks had the debt of Fannie and Freddie not been bailed out. As it was, a number of smaller banks failed when they had to write off their outsize investments in Fannie and Freddie's preferred stock.

Considering the "sovereign-banking nexus," what is new? Per usual in financial history, nothing. As Calomiris and Haber say, it is an "inherent conflict of interest." Will this "disastrous nexus" go away? Nope.

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington, D.C.

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