Following a suggestion I have been reading a book by Naomi Lamoreaux on the development of banking in New England1. It is called Insider Lending: Banks, Personal Connections, and Economic Development in Industrial New England.
She makes a number of excellent points in the book, and, to me,
anyone with an interest in the development of modern banking should give
it a look. Quite a few of the points she makes relate to the way that
the improving understanding of credit risk, and the development of
modern risk management, was, to a large extent, responsible for the
development of modern, large banks.
I would argue, consistent with my earlier post on regulation,
that it was not solely this, as an increase in regulation did play a
major part, but I think it was more of a virtuous (or perhaps vicious)
circle – with an increase in the size of banks, and an increasing
ability to lend to whoever happened to turn up to the bank driving
further regulation – which then effectively forced the smaller banks to
grow or perish – creating more regulation.
The central point of the book is simple – early banking in the US
(and, she presumes, elsewhere) was severely hampered by an inability to
assess credit risk, so what happened was when a bank was founded it
generally had several directors, men (and they were all men) of
substance who effectively both lent their names to the bank and risked a
large part of their fortunes in the venture.
In return, what they got was access to the banks funds, with a
typical bank lending between 20 and 50% of its funds either to the
directors or family members of the directors – the “insiders” of the
title. They were, to an extent, protected from unlimited liability by
the bank’s charter, but this protection was often more illusory
than real as to default would normally not only spell the end of the
bank, but also the reputation of the individual directors.
The result was that the directors typically had an overwhelming say
in the allocation of the bank’s lending, and they often lent to
themselves or to others they knew well.
While today this may be looked on askance (and as possible criminal
activity) then it was considered normal business for the reasons set out
above. The difficulty of assessing credit risk meant that only lending
to people you knew well (and, presumably trusted) was reasonably safe
and, as you effectively had your own money on the line, you wanted to be
This had several effects – most people were effectively locked out of
the banking system until they reached a point where they were rich
enough to either own their own bank or to know someone who did. The
second was that banks tended to be small – really small – with around 6
directors each and few employees. They also tended to have really high
capital and liquidity ratios and charge really big margins. This then
locked still more people out of the borrowing market.
The development of modern risk management practice, in all fields but
particularly credit risk management, put paid to this model. While a
few micro banks lingered into the modern era (and a few unit banks
survive in the US) the bulk either went out of business or were bought
out in the period up to the first world war.
The simple fact is that bigger banks, once you can overcome the
difficulty of finding the good risks to lend to, are much, much more
efficient2. If you can lend to more people, and people you do
not personally know, you do not need your (comparatively expensive)
directors to take every decision. You can directly obtain
diversification benefits, cutting down losses per dollar lent. You can
also, as a consequence, reduce your liquidity and capital ratios so you
can drive more lending off the same amount of deposits (not, of course,
that you can lend more than you have in deposits) and you can generally
make more money.
For those campaigners for “social equity” it also makes a clear point
– without modern risk management the poor are effectively locked out of
the banking system entirely – so if they want (or need) to borrow funds
they need to go to the loan sharks to get one. Personally, I would
prefer to pay 6 to 10 percent to a bank than 20 to 50 percent to a loan
shark. The bank also tend to not threaten to break my legs for
non-payment. Banks can be funny that way.
The directors also become much more removed from the day-to-day
operations,becoming more like the modern directors of a bank, able to
reduce the risk to their own personal assets that may result from a bank
I would encourage readers to have a look for this book and give it a
read, as it fills in a hole often left in the discussions on the
development of modern banking.
1. For those not familiar with the term, or who may be thinking of
another New England as there are several, she means the US states to the
north east of New York.
2. They can also, as I pointed out earlier, deal with the regulation
better, and they can lobby government more effectively – i.e. be more
efficient rent seekers.