Yue, Luo & Ingram (2013). The Failure of Private Regulation: Elite Control and Market Crises in the Manhattan Banking Industry

Authors:

Lori Qingyuan Yue – USC Marshall School of Business

Jiao Luo – Carlson School of Management, University of Minnesota

Paul Ingram – Columbia Business School

Interviewers:

Deborah Anderson – Saïd Business School, University of Oxford

Heli Helanummi-Cole – Saïd Business School, University of Oxford

Article link: http://journals.sagepub.com/doi/abs/10.1177/0001839213476502

Question 1. We found the empirical case you chose interesting, particularly since it’s set in the mid- 19th through early 20th Century. Can you tell us about the motivation for the article?

We started this study when we were all in Columbia University in 2008. New York at the time was the epicenter of an on-going financial crisis. We were intrigued by how banks responded to another financial crisis that happened 90 years ago with the same epicenter in an era without a central bank, the taxpayers’ bail-out, or the concept of “too-big-to-fail.” We found that banks ran a self-regulation program through local clearing houses during the National Banking Era (the time period from the end of the Civil War to the establishment of the Federal Reserve at the end of 1913). Banks organized collective actions. During calmer times, clearing houses cleared checks and inter-bank transactions for member banks, and during financial crises, they united the resources of local banks and organized mutual lending to help members survive.

We were first interested in how banks were able to solve the collective action problem and discovered that elite networks had played an important role in monitoring individual banks’ behaviors and enforcing self-regulatory norms. Then, the question is, if this self-regulation had been so effective, why it would eventually be replaced by public regulation? We found that the failure of this self-regulation program was not caused by internal problems such as free-riding, as the rational choice theorists would predict. Instead, what happened was that at the time there was an emerging organizational population called the “trust companies” that did similar business to banks but were not subject to the banking regulation. Commercial banks saw the competition from trust companies as “unfair.” They used the clearing house as an instrument to disadvantage trust companies and excluded them from participating into the collective action. What happened during the Panic of 1907 was that the financial crisis originated from the investment failures of several trust companies, and the New York Clearing House refused to rescue their trust company rivals in time. The financial crisis escalated, and eventually developed to a degree beyond the control of the clearing house. After the financial crisis was over, people reflected on the serious consequences of the crisis, and they pointed to the limitation of private regulation. That is the conflict of interests of a double role as a player and a regulator in the market. Then the Federal Reserve was introduced. Insights that we learn from the history of banking private regulation can enhance our understanding of modern industry regulation and provide guidance for future policy development.

Question 2. We were impressed with the amount of effort that must have gone into collecting and analysing the historical data – for example, you present analysis of the interlock network density, social-club network density, the impact of institutional exclusivity on bank failures, various descriptive statistics, etc., in addition to some analyses that were excluded due to space constraints.  What were some of the challenges you encountered when accessing, collecting, and analysing the data? What advice do you have for scholars who are interested in studying historical cases?

Data collection was a slow process. We spent many hours in places like the Columbia University libraries, the New York Historical Society, the New York Public Library, the New York Federal Reserve Bank, the New York Clearing House library, and at Forbes Inc. (the original publisher of Social Directory) to scan historical documents and code the data. Because the materials were historical documents that had to be retrieved from off sites, we got familiar with some librarians. They joked that we worked so hard that we really deserved to win some award.

The research process was very rewarding. As social scientists, we are interested in how social conditions affect people’s decisions and organizations’ behaviors and how activities by people and organizations affect our society. What happened in the past has a lot to teach us in this regard, and exploring history is indeed an adventure.

As to advice for scholars interested in studying historical cases, what some of us like to do when visiting a new city is to spend some time in the local museums and libraries. From these places, you get to know what unique geographical conditions, natural resources, cultures, and important industries are in the local community. These factors help to explain why certain types of organizations are founded and thrive. Museums and libraries sometimes keep good records of local industries and have books that record unique stories. These materials are good sources for research. Things are getting easier nowadays with the advancement of digital technology. We are confident that the increased availability of historical data will help researchers to conduct more fascinating research.

Question 3. While rich historical data provides a fruitful starting point for interesting analysis and a strong theoretical contribution, it does also raise many challenges in framing and structuring the final paper. This can sometimes seem a daunting process from a doctoral student point of view. How did your paper evolve during the review process? Did you have to leave some things out or collect additional data?

The paper changed substantially during the review process, thanks to inputs by the editor and reviewers. We were initially interested in explaining why the clearing house as a private form of regulation worked so well for a long time period, and had the failure of the private regulation as a relatively small part of the theory. However, we later discovered that the failure of the clearing house actually tells us more about the limitation of private regulation. When people talk about the failure of private regulation, the first thing that they think of is the collective action problem. What our paper reveals is a problem that is more deeply hidden. Regulations specify the rules of behavior and tend to have distributional consequences. How regulations are constructed therefore is often a result of power struggles, and the effectiveness of private regulations in governing a market depends on whether the conflict of interests can be well balanced.

As advice to doctoral students we would stress that reframing a paper requires that you really understand your research context as well as the literature. Only by doing that, you are able to figure out what new insights that your empirical setting offers that is either not covered by the literature or contradicts the prediction of existing literature. For our research, studying the successful operation of the clearing house is interesting, but studying its failure is even more interesting because the failure is not the opposite process of success, as we typically would assume. So the insight is what has caused this asymmetry. Pursuing this research question enables us to find novel insights regarding the failure of private market governance institution.

Question 4. Follow-on research has considered the implications of your findings, for example, in corporate interlocks. Given the richness of your findings, we find it interesting that the response has largely focused on exploring collective action during times of financial crises and panics. What other settings would you consider the findings to apply to? How do you think your findings could connect to collective action in non-financial crisis settings?

It is true that much of the follow-up research has focused on collective action during times of financial crises. There is, for example, some follow-up research on banks’ collective action during financial crises. One paper (published in American Journal of Sociology) expands the scope of investigation from New York to the whole nation and investigates the impact of community structures on a unique form of business collective action (i.e., issuing local currencies) that banks took during the Panic of 1907. The second paper (published in American Sociological Review) investigates the consequences of different collective actions (bank-only mutual lending vs. involving community to issue local currencies) on the evolution of bank interlocks. Different collective action experiences shaped banks’ responses to the classic collective action problem of the “exploitation of the big by the small”, and influenced how big banks treated their smaller counterparts in the post-crisis period. The third paper (working paper) studies the institutional legacy effect and shows that banks’ experience in an earlier panics (1893) affected the forms of collective action taken in 1907. These papers are available upon requests.

Empirically, there are, however, several examples of collective action in non-financial crisis settings. Private regulation has become an important form of regulation in industries like coffee, flower, forest products, and textiles over issues including labor and environmental protection. Private regulation programs in these industries similarly face the institutional fragmentation problem as some programs have been designed as a competitive tool to disadvantage rivals. Competition between different private regulation programs has created a problem of “a race to the bottom” in some situations and lowered the credibility of the whole private regulation field in others. Institutional exclusiveness versus inclusiveness is again the problem that haunts these regulatory programs. Their effectiveness depends on the balance between the regulatory versus the distributive function of these private regulation programs.

Question 5. Thank you very much for taking the time to discuss your paper with us and for being so open with your responses to our questions. Your input provides valuable insight to ASQ Blog readers. Is there anything interesting about the paper or process we didn’t ask that you’d like to share?

Thank you for providing this opportunity to share our research experience with the ASQ Blog readers. Very thoughtful questions!

 

References:

Yue, Lori Qingyuan. “Community Constraints on the Efficacy of Elite Mobilization: The Issuance of Currency Substitutes during the Panic of 1907 1.” American Journal of Sociology 120.6 (2015): 1690-1735.

Yue, Lori Qingyuan. “The Great and the Small The Impact of Collective Action on the Evolution of Board Interlocks after the Panic of 1907.” American Sociological Review 81.2 (2016): 374-395.

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