It was a failure of regulation

The evidence from history is clear. Weakly controlled banking systems tend to have a high proportion

The bank failures of recent weeks have been shocking. For many people it is almost beyond belief that names such as Bradford & Bingley, HBOS, Lehman Brothers and Wachovia could disappear apparently just like that. Yet economic history tells us that the risk of banking crises is ever present, goes up in an age of globalisation as capital becomes more internationally mobile and requires effective regulation to be contained.

The most infamous banking crises in economic history were those of the 1930s and the worst affected country was the United States, in which 9,000 banks failed between 1929 and 1933, a period when the money supply and real GDP fell by 29 and 33 per cent, respectively. As is well-known, the Roosevelt administration responded to the crisis with a "Bank Holiday", the introduction of Federal Deposit Insurance, re-regulation of the banking system and closure of a further 1,000 banks, and then recapitalised the banking system through the Reconstruction Finance Corporation. By 1935, the government in effect owned about a third of the American banking system and the fiscal cost of state aid to the financial system was 13 per cent of GDP. This was not, of course, the end of capitalism but a necessary, temporary phase on the road to recovery in the later 1930s.

The banking crisis of the American Great Depression was an extreme event but the risks and the costs of a milder version are not trivial. It has been found that in recent decades there has been around a 2 per cent chance per year that a country will have a banking crisis and that the cumulative GDP loss when this happens is about 6 per cent of GDP. Moreover, World Bank research shows that the fiscal costs of a banking crisis are frequently 10 per cent or more of GDP.

Mainstream economists are well aware that important "market failure" issues arise in the context of banking. In a world of imperfect and asymmetric information, the banking system is prone to failures of monitoring by depositors (who face a free-rider problem) and excessive risk-taking ("moral hazard") by bankers. Bank runs are an ever-present risk in a context of uncertainty about the true value of bank assets and the inability of depositors to co-ordinate their actions. The implications are that solvent banks with liquidity problems may be forced into bankruptcy and that a scramble for liquidity may entail meltdown risks for the financial system. These points were long ago well articulated by writers such as Frederic Mishkin, and have found their way into the textbooks.

Several equally well-known and important policy lessons follow. These include the crucial role of the central bank as the lender of last resort and the fundamental importance of the state as a regulator and supervisor of the banking system. This should entail ensuring the capital adequacy of banks, overseeing risk management strategies, enforcing appropriate accounting standards and so on. When banking crises occur, the role of the government is to apportion losses between shareholders, depositors and taxpayers and to facilitate the recapitalisation of banks. The politics of this may be difficult but the alternative meltdown risk of inaction is much worse.

The historical evidence is quite clear. Badly regulated banking systems are much more likely to have a high proportion of non-performing loans and to fail. There were no banking crises in western countries in the Bretton Woods era of strict regulation and international capital controls that followed the debacle of the 1930s. Bank failures are generally not random events, although contagion can occur. In 1929, American banks were inadequately regulated and the banks that failed were those that had weak balance sheets before the crisis hit. In the Asian crisis of 1997-98, it was the weakly regulated Korean banking system that collapsed, while the well-regulated Singaporean system emerged unscathed.

Clearly, regulation can be excessive and can impose unnecessary costs. For example, the prohibition of universal banking in the United States by the Glass-Steagall Act of 1933 was a draconian overreaction, as were the restrictions on international capital movements in the 1950s. Nevertheless, a sound regulatory regime is fundamental to the successful functioning of the financial system and to financial stability, and is a central responsibility of government.

It must be questioned how well the British government has performed in terms of financial regulation. For example, the recent Financial Development Report of the World Economic Forum rated the UK only 23rd out of 52 countries on its financial stability index and saw the UK as having a relatively high risk of a systemic banking crisis. It is important that the government acts to prevent the banking crisis getting worse. But it will be poetic injustice if Gordon Brown eventually claims the credit for "saving the British banking system" (with taxpayers' money), given that the roots of the problem lie in the inadequate regulatory regime that he put in place.

Nicholas Crafts is professor of economic history at the University of Warwick