Two books that will enrich your understanding of banking and bank crises

Published in Real Clear Markets.

Over the summer, I had the pleasure of reading the prerelease versions of two books about banking and financial crises: Finance and Philosophy: Why We’re Always Surprised, by Alex J. Pollock, (Paul Dry Books, October 16, 2018), and Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi, by James Freeman and Vern McKinley (Harper Business, 2018). Pollock’s book is being released in October, and Freeman and McKinley’s book is already available. If the history of banking and financial crises interests you, I think you will find both books to be rich in content and enjoyable to read. I know I did.

In Finance and Philosophy Alex Pollock, a former president and CEO of the Federal Home Loan Bank of Chicago, applies his formidable intellect and a lifetime of banking experience to explain in a simple and entertaining way why we continue to have banking crises and why post-crisis regulatory reforms are doomed to fail.

Banking systems will be prone to crises so long as investors confuse risk and uncertainty writes Pollock. Risk can be modeled, assessed and managed, but not so uncertainty.

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Pollock recounts numerous historical examples where the accuracy of heuristic models evaporated once investors and regulators adopted models to guide their actions. For example, in the recent financial crisis, institutions relied on models to parse the risk in subprime mortgage-backed securities. To describe the impact of uncertainty, Pollock quotes Tony Saunders “[t]he rocket scientists built a missile which landed on themselves.”

In Pollock’s view, over confidence in heuristic models is especially problematic when models are sanctioned by bank regulators or the Federal Reserve. For example, time and again, investors have been crushed when uncertainty reveals that investments like government bonds—presumed to be “riskless” in regulatory models— aren’t. Or markets presumed to be deep and dependably liquid—like commercial paper—cease to function.

The confusion between risk and uncertainty is not limited to private bankers and investors—in Pollock’s view, it is endemic among the modern central bankers entrusted with managing the economy. Unable to anticipate economic uncertainty, their economic models often misinterpret the economic tea leaves and lead central bankers (Pollock’s would-be “philosopher kings”) to adopt policies that magnify financial instability as they did in the great inflation of the 1970s and the great moderation (a.k.a. the housing bubble) more recently.

Pollock’s observations and historical examples are compelling, and his wide-ranging discussion of banking and financial crises is not only accessible, but a pleasure to read.