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Banks, States, and Financial Crises

PRINCETON – The most recent phase of the financial crisis, since the collapse of Lehman Brothers in September 2008, has been characterized by large bank losses and the continued threat of bank collapses. The size of the calamity raises the question of whether small countries can really afford bank bailouts.

But the definition of “small” keeps changing: a few months ago, small meant Iceland, then it meant Ireland, and now it means the United Kingdom. The aftermath of the banking crisis requires thinking about not only the most appropriate form of banking legislation, but also the appropriate size of the state.

There has always been uncertainty about the best design of a banking system, and there has always been competition between different sorts of banking regulation. On the one hand, there is the idea – which defined banking for much of American history – that banks should be close to the risks that they must judge. This ideal grew out of Andrew Jackson’s titanic struggle with Nicholas Biddle and the Second Bank of the United States. Populism was pitted against the financiers, and populism won. As a result, most nineteenth-century US banks did not have branches, and were limited to one state.

The alternative approach was that of Canada, which, because of its roots in secure British rule, had much less fear of political centralization, and was prepared to tolerate a nation-wide banking system. Canada’s large banking system distributed risk more widely, and fared better in episodes of financial panic, whether in 1907 or in 1929-1933.