2 - Banking instability and risk shifting

Summary

The history of money, banking, and financial legislation can be interpreted as a search for a structure that would eliminate instability. Experience shows that this search failed and theory indicates that the search for a permanent solution is fruitless.

H. P. Minsky

Preamble

This chapter attempts to conceptualise and theorise the reasons why banking becomes unstable and why banking systems experience crises. This chapter is not about how crises should be tackled once they occur; rather, it is about why crises occur in the first instance. It is important to think conceptually about banking stability because it helps to organise and interpret the historical narrative of banking stability in the United Kindgom during the past two centuries.

The first section explains why banking instability matters by describing how banking crises can have widespread ramifications for the economy and even for political stability. The second section uses a hypothetical bank to explore the traditional reasons given in the extant literature as to why a bank might fail. It demonstrates the vulnerabilities in the nature of banks’ assets and liabilities that may make them prone to instability. The third section contends that these vulnerabilities highlighted in the extant literature are an incomplete explanation of banking instability. Consequently, this section takes a hypothetical bank and develops a theory of banking instability based on the incentive structures of bankers, shareholders and depositors. In particular, the concept of ‘risk shifting’, which is when bankers opportunistically – and unobserved by depositors – increase the risk of a bank’s asset portfolio, is highlighted.