Is Banking Unusually Prone to Risky Practices?

I think the answer is "yes," and that this becomes apparent if we understand the Darwinian character of competition, though this is not to suggest that competition invariably, or even typically, leads to corrupt behavior.

There are many analogies between biological evolution and commercial markets, and as a result words like "competition" and "equilibrium" are important both in evolutionary biology and in economics. In an article published in 1950 the economist Armen Alchian argued that standard economic results could be predicted as products of a struggle for survival among competitors, without need to assume conscious profit maximization by any of them. But the explicit analogizing of economic behavior to Darwinian theory is far older than 1950, and in fact reached its apogee in the decades following the publication in 1859 of The Origin of Species—in the movement that came to be known as Social Darwinism. In its extreme form Social Darwinism advocated eugenic breeding, to improve the human race, and the elimination of poor relief and other redistributive policies, viewed as interfering with the struggle for survival and hence with the survival of the fittest.

But the Social Darwinists had committed a big, though common, error, which is to confuse fitness with goodness. The "fitness" in Darwinian theory is adaptation to the environment, not improvement—which brings me at last to banking, and economic competition more generally. A competitive environment favors firms that adapt to that environment; and so to determine whether a market is working well from an overall social standpoint, one has to understand the environment, and the business behavior that best enables a firm to survive and thrive in it. An analysis so motivated is a fruitful application of Darwinian theory to competitive markets.

"Banking" traditionally meant borrowing from persons who want by investing to defer production or consumption (in other words, to save but be compensated for saving, rather than just stuffing their savings under their mattress) and lending the borrowed money to persons who want to save less and produce or consume more. Increasingly the word "banking" is defined more broadly, as virtually any form of financial intermediation, in recognition of the greater variety of investments made by what are still called banks in our still lightly regulated financial system. But the traditional form of financial intermediation is all I need to discuss in order to make my point.

The obvious problem for a bank is how to earn a spread—that is, how to lend at a higher interest rate than it borrows, as otherwise it will not cover its costs. The standard answer is to borrow short and lend long. Short-term interest rates are lower than long-term rates because the risk of default is lower (there is no need to predict the borrower's long-term health) and because the borrower retains liquidity, which is valued—in the traditional demand deposit the borrower can withdraw at a moment's notice the money that he's lent the bank (a deposit is a loan). Because a long-term loan is riskier and the lender surrenders liquidity, long-term interest rates are higher, so by borrowing short and lending long the bank earns the spread it needs to survive and thrive.

The shorter the term of the bank's borrowed money, and the longer the term at which it lends, the bigger the spread but the greater the risk of default. If the lenders to the bank decide that the bank is making risky loans, they, or some of them, may decide to withdraw their money. The more who do, the riskier the position of the other short-term lenders to the bank is, and so they will follow suit--hence bank runs. Because the bank's lending is long term, the bank can quickly find itself with no liquid capital and with long-term assets consisting of loans that are risky (which is what precipitated the depositors to flee the bank) and hence may be likely to default.

One might think that, cognizant of such risks, banks would be cautious borrowers and lenders; they would not borrow so short (and thus risk a run) or make such long-term (and therefore risky) loans. But that need not be true. Maximizing spread may be very risky in the long run, but in the short run it may generate very high profits that shareholders and managers may be able to pocket and may compensate them for the risk of a future disaster, the costs of which will be borne by others. Banks that follow a more cautious strategy and therefore have lower profits may have trouble attracting and retaining talented employees and may not be able to hold on to short-term capital (the demand deposits) against the competition of more profitable banks (profitable because less risk averse) for short-term capital.

As we know from the global financial collapse of 2008 and the ensuing global economic depression (and there are numerous historical precursors), the collapse of a banking industry can create large external costs. For, to repeat, Darwinian evolution is toward fitness rather than goodness. A high-risk industry with frequent bankruptcies may be optimally adapted to its economic environment, but its risks may create serious danger for the economy as a whole. That is the argument for federal deposit insurance and other traditional, though now largely dismantled, regulations of bank solvency. Other high-risk industries with frequent bankruptcies, such as the airline industry, do not pose macroeconomic risk because they are small and because the firms can continue operating in bankruptcy; they do not experience runs that leave them assetless. For such industries, deregulation may be optimal. But for banking it is not.

In recent decades some influential conservative economists, notably Alan Greenspan, the long-term chairman of the Federal Reserve, committed a variant of the Social Darwinist fallacy. They deemed markets, including financial markets, as "self-regulating," in the sense of achieving socially optimal results without need for traditional regulatory controls. At the urging of these economists and under pressure from the financial industry itself, some regulatory controls were rescinded and others ceased to be vigorously administered. The underlying assumption was that markets "work." They do work, but in much the same way that biological evolution works. Biological evolution has produced a marvelous variety of life forms, and economic evolution has produced a marvelous variety of products and services that have greatly increased human well-being. But both types of evolution produce "good" results only as by-products to the struggle for survival. Unregulated all they can achieve is fitness in the sense of adaptation to the environment. That may be good enough in most industries, but it is not good enough, for the overall health of the economy, in banking.

Lax regulation, particularly of nonbank banks like Bear Sterns, Lehman Brothers, and Merrill Lynch, encouraged sharp banking practices. Firms in a competitive market cannot afford to be very ethical, any more than a tiger or other predator can afford to be gentle or kind. The firms will be under heavy pressure to engage in any highly profitable practice they can get away with, even if the profits that the practice promises are short term, provided those profits are great enough to dispel or at least greatly lessen the concern of managers and other key employees and investors with the long term. The short-term orientation will influence the business decisions of the managers and other employees (loan officers, traders, etc.) who exercise discretion; they will try to make as much money for themselves and their firms as they can, as quickly as they can, to avoid economic extinction.

The Darwinian analogy of markets to nature is apt—and it is a warning against a certain type of economic complacency that appears to have contributed decisively to the economic doldrums in which much of the world is languishing, as well as to the frauds and other corrupt practices in banking that have surfaced. When an industry's structure and centrality to the economy pushes it toward assuming macroeconomic risk, the need for careful regulation is acute.