Tag Archives: financialization

Technology and Financial Inclusion in North America

Did Railroads Make Antebellum U.S. Banks More Sound?

By Jeremy Atack (Vanderbilt), Matthew Steven Jaremski (Colgate), and Peter Rousseau (Vanderbilt).

Abstract: We investigate the relationships of bank failures and balance sheet conditions with measures of proximity to different forms of transportation in the United States over the period from 1830-1860. A series of hazard models and bank-level regressions indicate a systematic relationship between proximity to railroads (but not to other means of transportation) and “good” banking outcomes. Although railroads improved economic conditions along their routes, we offer evidence of another channel. Specifically, railroads facilitated better information flows about banks that led to modifications in bank asset composition consistent with reductions in the incidence of moral hazard.

URL: http://econpapers.repec.org/paper/nbrnberwo/20032.htm

Review by Bernardo Bátiz-Lazo

Executive briefing

This paper was distributed by NEP-HIS on 2014-04-18. Atack, Jaremski and Rousseau (henceforward AJR) deal with the otherwise thorny issue of causation in the relationship between financial intermediation and economic growth. They focus on bank issued notes rather deposits; and argue for and provide empirical evidence of bi-directional causation based on empirical estimates that combine geography (ie GIS) and financial data. The nature of their reported causation emerges from their approach to railroads as a transport technology that shapes markets while also shaped by its users.

Summary

In this paper AJR study the effect of improved means of communication on market integration and particularly whether banks in previously remote areas of pre-Civil War USA had an incentive to over extend their liabilities. AJR’s paper is an important contribution: first, because they focus on bank issued notes and bills rather than deposits to understand how banks financed themselves. Second, because of the dearth of systematic empirical testing whether the improvements in the means of communication affected the operation of banks.

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In 19th century north America and in the absence of a central bank, notes from local banks were substitutes among themselves and between them and payment in species. Those in the most remote communities (ie with little or no oversight) had an opportunity to misbehave “in ways that compromised the positions of their liability holders” (behaviour which AJR label “quasi-wildcatting”). Railroads, canals and boats connected communities and enabled better trading opportunities. But ease of communication also meant greater potential for oversight.

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ACJ test bank failure rates (banks that didn’t redeem notes at full value), closed banks (ceased operation but redeem at full value), new banks and balance sheet management for 1,818 banks in existence in the US in 5 year increments between 1830 and 1862. Measures of distance between forms of communication (i.e. railroads, canals, steam navegable river, navegable lake and maritime trade) and bank location emerged from overlapping contemporary maps with GIS data. Financial data was collected from annual editions of the “Merchants and Bankers’ Almanac”. They distinguish between states that passed “free banking laws” (from 1837 to the early 1850s) and those that did not. They also considered changes in failure rates and balance sheet variance (applying the so called CAMEL model – to the best of data availability) for locations that had issuing banks before new transport infrastructure and those where banks appear only after new means of communication were deployed:

Improvements in finance over the period also provided a means of payment that promoted increasingly impersonal trade. To the extent that the railroads drew new banks closer to the centers of economic activity and allowed existing banks to participate in the growth opportunities afforded by efficient connections.(p. 2)

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Railroads were the only transport technology that returned statistically significant effects. It suggested that the advent of railroads did indeed pushed bankers to reduce the risk in their portfolios. But regardless of transport variables, “[l]arger banks with more reserves, loans, and deposits and fewer bank notes were less likely to fail.” (p.20). It is thus likely that railroads impact banks’ operation as they brought about greater economic diversity, urbanisation and other measures of economic development which translated in larger volume of deposits but also greater scrutiny and oversight. In this sense railroads (as exogenous variable) made banks less likely to fail.

But ACJ note that means of transportation were not necessarily exogenous to banks. Reasons for the endogeneity of transport infrastructure included bankers promoting and investing in railroads to bring them to their communities. Also railways could find advantages to expand into vigorously active locations (where new banks could establish to capture a growing volume of deposits and serve a growing demand for loans).

Other empirical results include banks decreased the amount of excess reserves, notes in circulation and bond holdings while also increased the volume of loans after the arrival of a railroad. In short, considering railroads an endogenous variable also results in transport technologies lowering bank failure rates by encouraging banks to operate more safely.

Comment

The work of AJR is part of a growing and increasingly fruitful trend which combines GPS data with other more “traditional” sources. But for me the paper could also inform contemporary debates on payments. Specifically their focus is on banks of issue, in itself a novelty in the history of payment systems. For AJR technological change improves means of payment when it reduces transaction costs by increasing trust on the issuer. But as noted above, there are a number of alternative technologies which have, in principle, equal opportunity to succeed. In this regard AJR state:

Here, we describe a mechanism by which railroads not only affected finance on the extensive margin, but also led to efficiency changes that enhanced the intensity of financial intermediation. And, of course, it is the interaction of the intensity of intermediation along with its quantity that seems most important for long-run growth (Rousseau and Wachtel 1998, 2011). This relationship proves to be one that does not generalize to all types of transportation; rather, railroads seem to have been the only transportation methods that affected banks in this way.(p4)

In other words, financial inclusion and improvements in the payment system interact and enhance economic growth when the former take place through specific forms of technological change. It is the interaction with users that which helps railroads to dominate and effectively change the payments system. Moreover, this process involves changes in the portfolio (and overall level of risk) of individual banks.

The idea that users shape technology is not new to those well versed in the social studies of technology. However, AJR’s argument is novel not only for the study of the economic history of Antibellum America but also when considering that in today’s complex payments ecosystem there are a number or alternatives for digital payments, many of which are based on mobile phones. Yet it would seem that there is greater competition between mobile phone apps than between mobile and other payment solutions (cash and coins, Visa/Mastercard issued credit cards, PayPal, Bitcoin and digital currencies, etc.). AJR results would then suggest that, ceteris paribus, the technology with greater chance to succeed is that which has great bi-directional causality (i.e. significant exogenous and endogenous features). So people’s love for smart phones would suggest mobile payments might have greater chance to change the payment ecosystem than digital currencies (such as Bitcoin), but is early days to decide which of the different mobile apps has greater chance to actually do so.

Wall Street (1867)

Wall Street (1867)

Another aspect in which AJR’s has a contemporary slant refers to security and trust. These are key issues in today’s digital payments debate, yet the possibility of fraud is absence from AJR’s narrative. For this I mean not “wildcatting” but ascertaining whether notes of a trust worthy bank could have been forged. I am not clear how to capture this phenomenon empirically. It is also unlikely that the volume of forged notes of any one trusted issuer was significant. But the point is, as Patrice Baubeau (IDHES-Nanterre) has noted, that in the 19th century the technological effort for fraud was rather simple: a small furnace or a printing press. Yet today that effort is n-times more complex.

AJR also make the point that changes in the payments ecosystem are linked to bank stability and the fragility of the financial system. This is an argument that often escapes those discussing the digital payments debate.

Overall it is a short but well put together paper. It does what it says on the can, and thus highly recommended reading.

Models of Safe Banking? The European Savings and Cooperative Banks

Savings banks and cooperative banks in Europe

By: Dilek Bülbül, Reinhard H. Schmidt and Ulrich Schüwer (all at Goethe University Frankfurt am Main)

Abstract: Until about 25 years ago, almost all European countries had a so-called three pillar banking system comprising private banks, (public) savings banks and (mutual) cooperative banks. Since that time, several European countries have implemented far-reaching changes in their banking systems, which have more than anything else affected the two pillars of the savings and cooperative banks. The article describes the most important changes in Germany, Austria, France, Italy and Spain and characterizes the former and the current roles of savings banks and cooperative banks in these countries. A particular focus is placed on the German case, which is almost unique in so far as the German savings banks and cooperative banks have maintained most of their traditional features. The article concludes with a plea for diversity of institutional forms of banks and argues that it is important to safeguard the strengths of those types of banks that do not conform to the model of a large shareholder-oriented commercial bank.

URL: http://econpapers.repec.org/paper/zbwsafewh/5.htm

Review by Anthony Gandy

In recent years I have had the pleasure of teaching banking strategy and banking regulation to professional bankers, the vast majority from the Anglo-Saxon sphere. This is a real challenge, they have greater experience of retail, business and corporate banking than I will ever obtain. However, one thing I do know is that they struggle to cope with the concept that the listed, publicly traded, universal bank is not the only institutional model in town. It is of course not the dominant model in many countries. There are real rivals many different backgrounds that challenge the listed banks and have many strengths; to a large degree these strengths maybe due to the restrictions placed upon them.

Summary

The paper Bülbül, Schmidt and Schüwer is a White Paper (No. 5) on Policy from the Center of Excellence SAFE – Sustainable Architecture for Finance in Europe (Goethe University Frankfurt) and was distributed by NEP-HIS on 2014-01-17. It outline the characteristics of savings banks (those with a public ownership foundation, even if that is no longer the whole case) and cooperative banks across Europe and detail the history of these two institutional forms in German, Austria, France, Spain and Italy. Clearly the primary example is Germany where the three-tier banking structure is live and well (if we exclude a few issues!). In Germany there is a co-existence of public savings banks, cooperative banks and private banks. In other regimes the model has changed, but in the case of say France, the cooperatives are incredibly strong even if some of the localism of these institutions has now been lost.

The authors define seven features of savings banks; however, through the passage of reform (some they argue may have been misguided) only the first two are now common across the markets they have reviewed:

  1. A focus on savings and savings mobilization
  2. A clear regional and even local focus
  3. They were/are “public” banks owned or sponsored by a public body in a specific region or locality, and those authorities had/have “obligations” in respect of these local institutions
  4. They are organised under a “public” law, though the authors do not really define this
  5. They were expected to support the local economy and the local people and financially sustainable enterprises
  6. They were expected to adhere to the region or locality of the sponsoring public body – thus avoiding competition between such banks
  7. Maybe most importantly they were part of a “dense and closely cooperating networks of legally independent institutions that constitute a special banking group”

While, to all intense and purposes the seven criteria still hold good in Germany for savings banks, elsewhere it now tends to be just the cooperative banks which maintain the sense of locality, network and non-competition between local and regional players. Even here though, many cooperatives look and act like major national banking groups, some are even competitors in the investment banking markets.

The authors review the two hundred year history of the German savings and cooperative banks, and that of other nations. Though, of course, this is done very swiftly given the space limitations they have. They also try to illustrate how changes in the system has led to weaknesses in some industries which have moved away from the German model. As is outlined in the discussion below, the end of cooperation and coordination of between savings banks in Spain, where local savings banks did not compete in other regions, has had enormous consequences.

While the history is brief, it is informative. I for one was not aware that Raiffeisenbank was named in honour of Friedrich Wilhelm Raiffeisen who in the 19th Century established the concept of rural cooperative banks networked to centralised services organisations. The name is also common to Austrian cooperative banks and is the foundation of the movement elsewhere. I feel I should have known this. The history, especially in recent years is also important in showing why Germany has performed differently in this sector than other countries which ostensibly had similar three-tier frameworks in the past.

In the other country reviews, the focus is more on the last twenty five years. In France for example the cooperative banks have come to dominate much domestic and even international banking. They absorbed the smaller French public savings institutions (through the mergers which resulted in Banque Populaire Caisse d’Epargne (BPCE)) while Crédit Mutuel (CM) and incendie-du-credit-lyonnais[1]Crédit Agricole (Credit A) have acquired a number of private banking groups building corporate and investment franchises. Of course the ultimate expression of this was Credit A’s acquisition of, how shall we put it, the accident prone Crédit Lyonnais giving it stake in corporate and international banking in France.

The author conclude by reviewing (as they do also in the country reviews, especially in the German one) past and current literature on whether public savings banks and cooperatives are inefficient, not incentivised to be competitive or even whether they carry higher risk. Their conclusion is that older research which support these points have now been supplanted by newer research which invalidates these arguments, especially in the light of recent events.

Discussion

One could argue that the case they make in their paper that German local public savings banks did not suffer to any large degree in the financial crisis could be countered by two points. Firstly, while the local savings banks had little exposure to securitised markets or to southern European debt, the structure of their industry would not really allow this anyway. These banks are local, however, they also provide funds to the Landesbanken which act as the central services and, effectively, the centralised treasury. It is they which then use funds to access corporate, investment and international markets. As the authors have point out, the Landesbanken have been hard hit in the financial crisis. Effectively the savings bank and the cooperative banking sector disaggregate the banking activity network into those which take in deposits and fund local projects and those which play a centralised role supporting the local institutions with an infrastructure and acting as their representatives in international wholesale markets. So they do not make perfect comparators to the more integrated large commercial banks. Secondly, while German has suffered from exploring the deposits of its savings banks and other banks abroad to fund various assets, the local German economy has not suffered, so the savings and cooperative banks have not been tested at local level, not this time around anyway.cartoon120621_2_full_600x400[1]

Secondly, the Italian section is a maybe little brusque. While savings banks and cooperatives along the German model have existed since the late 19th century, it is stated that they have not really established themselves to such a large extent and have been privatised. However, some of the arguments put forward for the benefits of public savings and cooperative banks are that they maintain localism. While Italy has clearly done much to privatise and get local politics out of their banks, they still certainly maintain more local banks than say a UK or Ireland as a proportion of their banking industry. In addition, while the word “Foundations” is mentioned iceberg-montepaschi[1]once, we rather skip over the important role they play in the governance and ownership of certain Italian banks in which the Foundations play such a large role and which still own a large proportion of the bank, including and rather notably the oldest of them all, Banca Monte dei Paschi di Siena, which so obviously faces an existential crisis.

Policy and Teaching

The public savings industry which the authors really find was badly hit by financial crisis was the Spanish one. However, they make a very interesting point that the industry in Spain had already abandoned many of the seven characteristics of public savings banks the authors identified. Indeed they make the very strong case that by allowing the savings banks in Spain to become national and to expand in areas they had little experience, they were attracted to the booming area of commercial mortgages, the vast majority used to fund the property bubble which would so damage Spain when it burst.

This last point is an interesting one as it shows the consequences of changing a system of ownership and governance under pressure to reform for only one reason, in this case the European standardised view of competition. Given banks are at the heart of the monetary system, consequences elsewhere in the economy have to be considered. Until the 1970s the Spanish savings banks were public institutions and somewhat politicised. Accession to the EU in 1986 brought pressure to reform and to liberalise, and yet while elements of competition were reformed, the governance of these institutions was not improved; fiefdoms remained, spurred on by growing competition. Of course the EU is hardly to blame for house price falls of up to 53.5% in Spain, but it does emphasise the importance of working through the long term consequences of policy changes which may interact with other events.

This paper not only gives teaching staff the opportunity to expose students to other banking governance and ownership possibilities, it discusses how changes to the model once common to all public savings and cooperative banks have potentially undermined some of their advantages and led to unintended consequences. It will be in the student reading list next year for sure.

When Accountants Come to Power

Management From Hell: How Financial Investor Logic Hijacked Firm Governance
By Robert R. Locke (lockerobert3@aol.com)
Paris: Boostzone Editions, 2012
57, ebook, ASIN: B007MOYC56 (RRP €5.50 – £4.42)

Abstract – Corporate governance now is strongly controlled by a «caste» of financial investors that forgets employees and other stakeholders as well as society at large. This control is a major cause of our current crisis and of a growing disbelief in modern capitalism. Why and how did this happen? A renowned American historian of management, Robert R. Locke, develops a well-argued and powerful point of view about the limits of financial investor capitalism and shows that more balanced models should be explored, like family business as well as Geman and/or Japanese corporate governance.

URL – www.boostzone-editions.fr

Review by H. Thomas Johnson
(Professor of Business Administration at Portland State University in Oregon and Distinguished Consulting Professor of Sustainable Business at Bainbridge Graduate Institute in Washington)

In Management From Hell, Robert Locke offers an alternative to the belief that the purpose of a business is to enrich a small elite caste of investor-capitalists who use financial markets and business institutions to trade the future of humanity and non-human life for unlimited personal financial gain. That alternative is the entity view of business in which the purpose of a business is to flourish for the indefinite future and serve the well-being of society as a whole by providing gainful employment to people (employees and suppliers) whose job is to sustainably supply the economic needs of other people (customers). The book begins by examining the impact on large corporations since the late 1970s of “investor capitalism,” a “proprietary” view of business that sees the activities and the capital of a corporation as controlled by its owner-investors and managed by their hired agents, all for the purpose of maximizing its financial returns, to which they – the investor-owners – claim exclusive rights. Locke draws on extensive historical research to show how advocates of investor capitalism used modern academic theories of economics and finance to justify the morally dubious claim that a corporation’s sole concern is to maximize the financial returns to its investor-owners and their delegated agents, without regard for how its activities affect other constituencies such as employees, customers, suppliers and non-human members of Earth’s life-sustaining biosystem.

Robert R. (Bob) Locke

During the 1980s and 1990s top corporate managers, despite their role as the investor-owners’ agents, gained effective control over corporate boards of directors and, implicitly, the power to set their own personal compensation. The spectacular rise in corporate CEO, CFO and other C-level compensation in the last 20 or so years (from salaries, bonuses and stock options) relative to the compensation of lower-level managers, employees and even investor-owners is well known and does not require further documentation here. Locke shows in Management From Hell and at greater length in his co-authored book with J.-C. Spender, Confronting Managerialism (Zedbooks, 2011) that top managers accomplished this change by gradually shifting strategic decision-making power to themselves and away from owners. They achieved that shift largely by promoting the claim that their special post-graduate business education (especially in MBA programs of elite U.S. business schools) put them in exclusive possession of special knowledge and expertise needed to efficiently run today’s complex, global corporations.

As a consequence of successfully marketing their supposedly unique management expertise gained from exclusive access to the nation’s most elite graduate business schools, top managers in the last generation ran large American corporations with impunity. Almost never were they held accountable for the social costs of the management practices they pursued to maximize financial returns for the personal gain of the owners and their “elite” agents. In retrospect it seems clear that many of those practices seriously impaired the vitality and strength of the American economy in the past 30 or so years.

Locke demonstrates persuasively that the damaging consequences of these investor-capitalist management practices were not experienced to the same degree outside America, where management practices were guided by alternative economic philosophies that viewed the purpose of a business in terms of the interests of a much broader constituency than just investor-capitalists and their manager-agents, and not just in terms of maximizing immediate financial returns. He shows how large corporations in Germany and Japan are managed from an “entity” perspective that views success as ensuring the corporation’s long-term survival and sustainability on behalf of all its constituents – employees, customers, suppliers, communities and shareholder/owners — not just owners and their manager-agents. A firm run from an entity as opposed to a proprietary perspective measures success in terms of conditions that contribute to firm sustainability – e.g., average longevity of employees (presumes that returns on investment in humans increase with tenure of employment), employee training, customer satisfaction, reputation, quality of design and delivery, and financial returns (sufficient to flourish and develop over many generations, not maximum short-term profits).

H. Thomas Johnson

Locke cites research findings showing that American firms that are run from a proprietary perspective do report higher financial returns in the short run than do firms run from an entity perspective. In Germany or Japan, however, the entity firms, although earning less spectacular short-term returns, do earn respectable returns, and they live much, much longer. To indicate the long-term consequence of this difference, Locke cites a 2001 book by Richard Fosterand Sarah Kaplan entitled Creative Destruction: Why Companies That Are Built to Last Underperform the Market–And How to Successfully Transform Them. The authors of this book interpret the increasingly rapid rise and fall (turnover) of large corporations on American financial markets in the 20th century as evidence that the markets weed out less efficient firms by rewarding current financial performance over firm longevity. Although the authors view this outcome favorably, Locke points out that their conclusion begs the question,

“At what cost to individuals, society and Earth’s life-support system do markets achieve such outcomes?”

Indeed, in the post-1970s era of investor capitalism the “leaders” of American corporations (whether top managers working from inside a firm as agents for the investor-owners or take-over operators working for themselves from outside a firm) have pursued the goal of maximum financial returns at increasingly heavy cost to workers, communities, and government. It is not an exaggeration to say that top managers or investors no longer view a business corporation as a community of people (employees, managers, investor-owners, suppliers) serving people (customers and communities) for the economic well-being of society. Instead, they view a business corporation as a commodity with a market value/price set by traders in global financial markets. In other words, a corporation is viewed as a pool of investors’ financial capital seeking maximum returns, if not in one enterprise then by liquidating that enterprise and re-investing the capital in another enterprise ad infinitum.

Because it is assumed that financial markets obey the dogma of financial economics and value corporations according to their discounted current and expected future financial returns, then top management’s job inside a firm is to maximize those returns even if the steps management takes to do so destroy the firm by, say, off-shoring work to lower-wage countries, outsourcing supply purchases to force down prices of non-labor inputs, re-locating headquarters and bank accounts in other countries to reduce taxes and so forth. No different in principle, even if the steps taken are often more extreme, are the steps taken by an outside private equity firm that borrows funds in order to purchase a target corporation, take control and then pursue steps to increase the target firm’s market value by, say, cutting costs via layoffs, revising labor contracts to reduce wages, terminating employee pension contracts and so forth. In addition, private equity take-over firms often use their legal control of the target firm to pay themselves hefty management fees and other forms of compensation. They also borrow against the firm’s assets and draw out cash from its employee pension funds, and then use that cash to pay back the loans they borrowed to purchase the target firm originally. Eventually the private equity firm hopes to cut costs and raise the financial returns of the target firm sufficiently to re-sell it for more than their purchase price, pocket the difference, and walk away much richer. They leave behind a financially-strapped community of unemployed workers, bankrupt suppliers and tax-starved public services. In several chapters Locke enlivens his discussion of these practices with references to specific private equity take-over firms, especially Bain & Co., an example of the industrial-capitalist spirit at its most socially destructive and immoral, particularly its activities conducted in the 1980s and 1990s by Bain’s most famous partner, former Massachusetts Governor and 2012 Republican candidate for U.S. President, Mitt Romney.

This book is for anyone who is concerned about the precarious state of the US economy, including those who are, or plan to be, employed by large corporate businesses. Implicit in the book’s message is the conclusion that investor-capitalist management of “corporations-as-financial-commodities” is an important cause of the growing inequality of wealth and income in the American economy. The huge private fortunes amassed as a consequence of this inequality are being used increasingly to control elections and legislatures in the United States, threatening to replace democratic governance in American society with plutocratic control by a handful of unimaginably rich individuals, almost all of whom view the economy and society through the nineteenth-century liberal ideology of individualism and free markets.

N.B. See also the review by Dominique Turcq (Editor)