Why do banking crises occur?

Why did the U.S. banking crisis of 2007-2008 occur? Many accounts have chronicled the bad decisions and poor risk management at places like Lehmann Brothers, the now-vanished investment bank. Still, plenty of banks have vanished, and many countries have had their own banking crises in recent decades. So, to pose the question more generally, why do modern banking crises occur?

David Singer believes he knows. An MIT professor and head of the Institute's Department of Political Science, Singer has spent years examining global data on the subject with his colleague Mark Copelovitch, a political scientist at the University of Wisconsin at Madison.

Together, Singer and Copelovitch have identified two things, in tandem, that generate banking crises: One, a large amount of foreign investment surges into a country, and two, that country's economy has a well-developed market in securities - especially stocks.

"Empirically, we find that systemic bank failures are more likely when substantial foreign capital inflows meet a financial system with well-developed stock markets," says Singer. "Banks take on more risk in these environments, which makes them more prone to collapse."

Singer and Copelovitch detail their findings in a new book, "Banks on the Brink: Global Capital, Securities Markets, and the Political Roots of Financial Crises," published by Cambridge University Press. In it, they emphasize that the historical development of markets creates conditions ripe for crisis - it is not just a matter of a few rogue bankers engaging in excessive profit-hunting.

"There wasn't much scholarship that explored the phenomenon from both a political and an economic perspective," Singer adds. "We sought to go up to 30,000 feet and see what the patterns were, to explain why some banking systems were more resilient than others."

Where the risk goes: Banks or stocks? Through history, lending institutions have often been prone to instability. But Singer and Copelovitch examined what makes banks vulnerable under contemporary conditions. They looked at economic and banking-sector data from 1976-2011, for the 32 countries in the Organization for Economic Cooperation and Development (OECD).

That time period begins soon after the Bretton Woods system of international monetary-policy cooperation vanished, which led to a significant increase in foreign capital movement. From 1990 to 2005 alone, international capital flow increased from $1 trillion to $12 trillion annually. (It has since slid back to $5 trillion, after the Great Recession.)

Even so, a flood of capital entering a country is not enough, by itself, to send a banking sector under water, Singer says: "Why is it that some capital inflows can be accommodated and channeled productively throughout an economy, but other times they seem to lead a banking system to go awry?"

The answer, Singer and Copelovitch contend, is that a highly active stock market is a form of competition for the banking sector, to which banks greater risks.

To see why, imagine a promising business needs capital. It could borrow funds from a bank. Or it could issue a stock offering, and raise the money from investors, as riskier firms generally do. If a lot of foreign investment enters a country, backing firms that issue stock offerings, bankers will want a piece of the action.

"Banks and stock markets are competing for the business of firms that need to raise money," Singer says. "When stock markets are small and unsophisticated, there's not much competition. Firms go to their banks."

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