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Coronavirus and the Implications of Private Equity Buyouts in Healthcare



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As we face a coronavirus-induced health and economic crisis of uncertain duration, policy makers should be particularly concerned about private equity’s heightened use of debt to buy out healthcare providers and take them private, with no regulatory oversight.

Private equity firms have become major players in the healthcare industry—with investments reaching 855 deals and $100 billion in capital in 2018 alone—an historic high. Why has private equity accelerated its investments in healthcare in recent years? How can PE firms deliver their promised ‘outsized returns’ to investors on the backs of sick patients? We examine these questions in our new INET study, Private Equity in Healthcare: Who Wins, Who Loses?

Policy makers should take note of private equity’s heightened role in healthcare as the country hotly debates the financial model of an industry that represents 18 percent of GDP and rising. In 2018, healthcare prices continued to rise, with Americans spending $3.65 trillion on healthcare—4.6 percent more than in 2017—due to higher prices, not more visits to doctors or hospitals. Private equity firms and their deals lack transparency and accountability because they are almost completely unregulated under state or federal law.

As we face a coronavirus-induced health and economic crisis of uncertain duration, policy makers should be particularly concerned about private equity’s heightened use of debt to buy out healthcare providers and take them private, with no regulatory oversight. After the 2008 crisis, highly leveraged companies, whether publicly- or privately-owned, faced serious financial distress. And a disproportionate percentage of private equity owned companies went bankrupt compared to other comparable publicly-owned companies.[1]

In 2018, the median or typical debt leveraged in a PE healthcare buyout rose to 7x EBITDA (earnings before interest, taxes, depreciation, and amortization). This equals the highpoint of debt used in the 2006 bubble year—which led to high levels of financial distress and bankruptcy. The Covid-19 crisis is already taxing the US healthcare system; debt-induced financial instability will exacerbate the crisis. Note that if private-equity owned providers go bankrupt employees, patients, investors, and creditors lose, but PE general partners walk away because the debt is leveraged on the provider and PE partners typically invest less than 1-2 percent of the total purchase price.

In this context, how should government regulate private equity firms and other financial intermediaries that have penetrated healthcare markets for services so central to people’s ability to live healthy lives?

Interest in private equity’s role in healthcare exploded in 2019 when investigations revealed that two large private equity owned staffing firms—with a 30 percent share of the market for outsourced emergency room doctors—were at the heart of the surprise medical billing crisis. Patients who thought their insurance would cover their ER visit found instead that, in outsourced ER rooms, doctors could charge out-of-network rates, leaving patients with huge medical bills. Congressional debate over legislation to curb these abuses stalemated in early 2020 as private equity firms poured millions to lobby Congress to adopt watered-down legislation that would not substantially alter out-of-network rates.[2]

The coronavirus crisis raises even greater concerns over whether physician staffing firms and other outsourced healthcare services will continue to charge Covid-19 patients, who can least afford it, outrageous out-of-network fees.

We argue in this study that the classic private equity business model—of extracting value in a short time frame in order to meet interest payments on the high levels of debt typical of private equity buyouts and to deliver ‘outsized returns’ to investors—is rarely consistent with building a sustainable healthcare system for high quality patient care. Increasingly, medical professionals are also beginning to worry about losing control of decision-making and professional autonomy if they contract with private equity firms to manage their practices. PE’s focus on generating cash flow and exiting the investment in a five-year window puts pressure on doctors to increase volumes of patients seen per day, to overprescribe diagnostic tests or perform unnecessary procedures, or to save on costs by using shoddier but less costly supplies and devices.

We also document the dramatic rise of private equity investment in healthcare, which has grown exponentially since 2000, and accelerated since 2010. Taking into account all types of healthcare deals (LBOs, add-ons, growth investments, secondary buyouts), PE capital invested in healthcare grew from less than $5 billion per year in 2000 to $100 billion in 2018 – a 20-fold increase. Cumulatively, PE firms closed roughly 7,300 ‘deals’ totaling $833 billion since 2000, with 70 percent of these investments occurring since 2010. In 2018 alone, PE investments in healthcare reached an historic high—at 855 deals and $100 billion in capital invested that year.

We also examine how PE firms have used the classic leveraged buyout (LBO) model to buyout many small service providers and roll them up into national powerhouses with greater negotiating power vis-a-vis insurance companies, medical supply companies, and local healthcare systems. We particularly focus on four segments where PE firms have been active: hospitals, outpatient care (urgent care and ambulatory surgery centers), physician staffing and emergency room services, and revenue cycle management (bill collecting).

In each of these segments, private equity has spurred consolidation, raising the possibility, as Nobel Prize winning economist Joseph Stiglitz put it recently, that their goal is to “take advantage of others through market power, through individual vulnerabilities, and through inside or unequal information.”[3]

The salient findings in this study include the following:

The Private Equity Business Model

· Private equity firm investments in healthcare are largely short-term financial transactions – designed to make ‘outsized returns’ for themselves and their limited partner investors in a three to five year window. The primary business model is the leveraged buyout, in which PE buys out a healthcare enterprise, loads it with substantial debt that the enterprise must repay, and attempts to exit the investment in a three-five year window. The median, or typical, ‘hold time’ for a PE investment in healthcare was 4.6 years in the 2012-2015 period and 4.9 years in 2016-2019.

· Private equity’s current interest in healthcare is driven by market opportunities to consolidate enterprises in highly fragmented markets. PE serves as a market aggregator and reseller, using a well-developed ‘buy and build’ strategy. It establishes a ‘platform’ by buying out one enterprise and then adding on and rolling up a series of similar enterprises — consolidating them to achieve economies of scale and market power at the local, regional, or national level. It then exits the business via an IPO, a resale to a ‘strategic’ buyer, such as a hospital or insurance company, or a resale to another private equity firm, referred to as a secondary buyout. Since 2013, 35 percent of PE capital was invested in leveraged buyouts of one enterprise, 23 percent in secondary leveraged buyouts, and 35 percent in ‘add-ons’ to these buyouts. Comparing the number of deals executed by type of investment, almost three times as many deals were completed as add-on LBOs versus single LBOs.

· The buy-and-build strategy is an effective way to build market power without falling under the scrutiny of government antitrust agencies because each acquisition is too small to fall under the jurisdiction of the Federal Trade Commission. The median deal size of PE leveraged buyouts in healthcare is in the range of $60-70 million – smaller than deals in other industries.

· Private equity firms move in and out of healthcare markets – targeting the most lucrative market segments (e.g. outpatient care) or sub-segments (e.g. ambulatory surgery), cream skimming the ‘best targets,’ reselling them, and moving on to the next most attractive market. Private equity firms actively engaged in hospital buyouts in the 2000s through 2012, but found they could not make sufficient returns in this segment and moved on. Over the last decade, they shifted their investments to other lucrative niches – including health IT, outpatient care, ambulatory surgery services, anesthesiology, laboratory practices, emergency room management, burn units, trauma units, and radiology. More recently, PE firms have moved into additional physician specialties – dermatology, dental practice management, case management, ophthalmology, and orthopedics – as well as behavioral health. They are also active in ‘revenue cycle management’ or bill collecting.

· The private equity model in healthcare is one of low risk, as third party government and private insurers guarantee payments. It is one of high returns due to the extensive use of debt. In 2018, the median or typical debt leveraged in a PE healthcare buyout was 7X EBITDA (earnings before interest, taxes, depreciation, and amortization) – about equal to its highpoint in the 2006 bubble year.

· Private equity faces increasing competition in buying up outpatient, physician specialties, and other provider services as hospitals and payer organizations have realized the importance of building out their own vertically integrated inpatient and outpatient healthcare systems. As a result, the total price of buyout targets in 2018 increased to an historic high of 15.8X EBITDA—considerably higher than the PE economy-wide average of 11.5X EBITDA in that year. The high prices raise questions about the viability of the PE model in healthcare to exit these investments and achieve outsized returns in the future.

· Given private equity’s business model and on-going activity in healthcare, many medical professionals and their associations are expressing concern and hotly debating the pros and cons of PE buyouts—whether doctors lose control of decision-making or whether excessive debt and cost pressures push doctors to increase patient volumes to reduce costs, or increase unnecessary procedures to expand revenues.

PE Health Care Industry Trends

· Taking into consideration all types of healthcare deals (LBOs, add-ons, growth investments, secondary buyouts), private equity firms have closed roughly 7,300 ‘deals’ in healthcare totaling $833 billion since 2000. Investment activity particularly accelerated after passage of the Affordable Care Act in 2010, with 70 percent of all PE investments occurring since then. PE capital invested in healthcare grew from less than $5 billion per year in 2000 to $100 billion in 2018—a 20-fold increase.

· In 2018 alone, PE investments in healthcare reached an historic high — at 855 deals and $100 billion in capital invested that year.

· Membership in the PE industry association—the Healthcare Private Equity Association (HCPEA)—grew from 40 members in 2010 with investments in 500 companies to 74 members in 2019 with investments in 1,500 healthcare businesses.

· While mergers and acquisitions have grown substantially in the healthcare industry overall, the number of private equity M&As has grown at four times the rate of non-PE M&As. By 2019, private equity mergers and acquisitions represented 45 percent of all M&As in this sector.

Developments in Selected Healthcare Segments and Sub-segments

Between 2013 and 2019, 8 percent of PE investments were in the hospital segment of the industry compared to 30 percent in the outpatient services segment, with an additional 9 percent in ‘other healthcare services’ that include small physician specialty practices. PE firms also invested substantially in the following segments: healthcare technology systems (17 percent of all investments in 2013-2019), devices and supplies (17 percent), and pharma and biotech (15 percent).

Hospital Systems

· In the hospital segment, private equity firms used the highly leveraged debt model to buy out hospitals in the 2000s. By 2011, they owned 7 of the top for-profit chains, while the largest formerly- PE owned chain, HCA, continued to have 75 percent PE ownership. While HCA provided an example of a successful IPO, many others failed to achieve anticipated returns. After going on buyout sprees that led to huge debt encumbrances on healthcare systems, PE firms turned around and sold off assets in an attempt to forestall bankruptcies.

· The sagas of Community Health Systems (CHS), Quorum, Steward Health Care System, and IASIS Health Care most vividly illustrate what has become of the hospitals acquired by private equity in the 2000s—and what that has meant for the stability of health care markets and the community’s access to acute care services. The hospital chains’ faced major challenges in meeting loan obligations accumulated through LBOs of add-on acquisitions; and local health markets experienced instability caused by the pressure of high levels of debt in these national hospital systems and by the imperative to earn high returns for investors.

Outpatient Care, Urgent Care, and Ambulatory Surgery

· Private equity has invested substantially in outpatient care and ambulatory surgery services since 2010. While the proportion of healthcare workers employed in outpatient clinics is less than 10 percent of those employed in hospitals, their numbers grew at six times the rate of hospitals from 2005 to 2015 (albeit from a very low base), and numbered some 738,000 in 2015.

· Cumulatively, private equity has bought out 2,500 clinics and other small healthcare services in the last 20 years for a total of $158.5 billion. They particularly increased their investments from 2010 on: 81 percent have occurred since then. The next largest competitor group buying up outpatient clinics was hospitals, which accounted for the overwhelming majority of the remaining deals.

· Private equity’s strategy in outpatient care is similar to its approach in other healthcare segments. As a market intermediary, private equity is an aggregator and reseller, using a well-worn formula for consolidating and flipping entities in a low risk, high reward model. As competition gets tight in one segment or sub-segment, private equity moves on—prospecting for the next gold mine.

· In the urgent care sub-segment, two private-equity owned hospitals systems—Tenet and HCA—were the pioneers in buying up clinics and integrating them into their sprawling healthcare systems via mergers and acquisitions.

· Private equity firms with investments in urgent care between 2010 and 2018 were largely able to exit their investments within 3 to 6 years. But increasingly they are having difficulty exiting: In 2019, roughly 20 large PE-backed roll-ups in urgent care were nearing the end of their investment cycles and finding it difficult to exit their investments.

· Competition to buy up outpatient care centers in general has increased in recent years, as payers and providers seek to integrate them into their healthcare networks. This has allowed some PE firms to exit their investments by selling to these strategic actors.

· Ambulatory surgery centers (ACS) are a specialized niche or sub-segment in the outpatient segment that also experienced considerable growth in recent years. This sub-segment is also characterized by small fragmented, independent companies not affiliated with a hospital or health care system, which account for almost two-thirds (64 percent) of the market.

· Private equity firms took the lead in building out national chains of freestanding ambulatory surgical care centers. As of 2015, the two largest independent companies were both owned by private equity—Ambulatory Surgical Centers of America (AmSurg, owned by Kohlberg, Kravis, and Roberts) and United Surgical Partners International (USPI) (owned by Welsh, Carson, Anderson, & Stowe).

Physician Staffing Firms, Emergency Room Management, and Surprise Medical Billing

· Surprise medical bills from emergency room (ER) visits and ambulance services have become a major concern in recent years. Patients who go to the ER believe that their insurance will cover the costs for ER services in the hospital that accepts their insurance; but they often later find that the ER doctors bill them directly because, in fact, the hospital has outsourced the ER to a physician staffing company that is not covered by their insurance.

· In fact, the leading national physician staffing firms responsible for surprise medical bills are owned by private equity firms: Envision Healthcare (with 69,000 employees), owned by KKR, and TeamHealth (with 20,000 employees), owned by Blackstone. Together these two companies own 30 percent of the ER outsourced market. These national chains of ER specialists are the result of PE’s strategy of buying up small specialty practices and rolling them into national chains with substantial market power.

· Air and ground ambulances also have been a major source of surprise medical billing. The average cost for an air ambulance was over $36,000 in 2018, and 69 percent of bills were out-of-network—meaning that insured patients, in these cases, were billed directly for the services.

· Private equity owned companies dominate this sub-segment of healthcare. Two of the three largest ambulance transport companies are owned by private equity firms. KKR merged American Medical Resources (AMR) and Air Medical Group Holdings (AMGH) to create the largest provider of ground services and one of the largest for air transport services. Air Methods, also owned by private equity, reports that it accounts for nearly 30 percent of total air ambulance revenue in the US.

· In 2019, Congressional committees introduced legislation to curb surprise medical bills, but remained stalemated over specific provisions. Some legislators favor the adoption of a cap on out-of-network bills based on local in-network rates. Others insist that any capped payment be subject to arbitration so that out-of-network doctors can challenge the amount paid. Critics worry that this will lead to increases in healthcare costs and provide incentives for in-network doctors to go out-of-network to earn more. Private equity firms and other physician specialty associations have lobbied fiercely against a strict cap, while insurance companies favor it.

· Pending legislation has led financial analysts to re-evaluate the value of debt ladened Envision Healthcare, owned by KKR. The value of Envision’s debt fell from 97 cents on the dollar in May, 2019 to 73 cents on the dollar in August, 2019.

Collecting Medical Debt: Revenue Cycle Management (RCM)

· Private equity firms also have bought up and rolled up revenue cycle management companies—those responsible for hounding patients to pay their bills—including those accumulated as a result of the surprise medical billing by PE owned ER staffing companies. Medical debt is a major contributor to almost 60 percent of personal bankruptcies, and has grown in recent years due in part to increased deductibles in health insurance plans.

· Hospital uncompensated care and unreimbursed care has grown at about 3 percent since 2015, and they have responded by increasingly outsourcing bill collection to third party vendors with more efficient and updated IT systems and automated billing. Hospital demand for RCM outsourcing jumped 86 percent between 2015 and 2018.

· RCM is an attractive market for private equity because many firms have already invested in health IT, and extending IT innovations to the RCM segment is relatively straightforward.

· Early leaders in RCM innovation in the 2000s included PE owned hospital systems: Parallon, a subsidiary at HCA, and Conifer Health Solutions at Tenet Healthcare. More recently, PE firms have developed platforms to acquire a series of small RCM companies and roll them into national chains providing ‘one-stop shopping’ for a range of RCM activities; but to date, few have accomplished this goal and most hospital systems use more than one vendor.

· PE firms active in this segment include Blackstone, The Gores Group, Thomas H. Partners, Vista Equity, Waud Capital Partners, and Warburg Pincus, among others.

· The largest RCM company is Parallon, with 16,500 full time employees and 3,926 contracts. nThrive (Pamplona Capital) is second with 3,048 full time employees and 1,565 total contracts. The next largest 18 companies have just 100 to 1,500 contracts each.

· RCM companies are under scrutiny by the Federal Communications Commission (FCC) for aggressive tactics. Complaints to the FCC have increased; and lawsuits claiming violations of the Telephone Consumer Protection Act (TCPA) by RCM and other bill collections companies increased by 560 percent between 2010 and 2014.

· In August 2015, the FCC ruled that the decades-old Telephone Consumer Protection Act (TCPA) applies to calls by bill collectors to cell phones, and not just landlines – clarifying that debt collectors must confirm express consent before autodialing a cellphone. They are allowed one wrong number call to a cell phone. Violations of the TCPA incur substantial financial penalties.

· In sum, PE firms are on the forefront of the outsourced RCM segment in healthcare, pushing it toward consolidation. They have been involved in aggressive billing collection practices, including violating debt collection laws, suing low-income patients, and offering potentially exploitive medical loans. Recent investigations suggest PE- owned companies discontinue their most egregious practices once they come to light. Health care stakeholders must continue to track PE involvement, as well as the RCM segment more generally, to protect vulnerable patients from exploitative practices.


In the context of the current health and economic crisis, the future role and outcomes of private equity investment in healthcare is uncertain. The novel coronavirus pandemic provides private equity-owned healthcare companies with opportunities in some market niches and challenges in others. Hospitals already struggling with unmanageable debt loads will see revenues decline as lucrative procedures ranging from organ transplants to knee replacements are cancelled to free up beds in surgery wards and intensive care units. Urgent care centers will become an ever more vital part of the healthcare landscape as hospital ERs turn away patients with less serious health problems. The private equity firms supplying tens of thousands of emergency room doctors to hospitals across the country will see a huge increase in patients treated by these doctors and an opportunity to reap a financial bonanza via high out-of-network charges for these services. But they risk a backlash from the public and Congressional action to limit the high prices their business model is based on going forward. Finally, the outcome for revenue cycle management firms is uncertain. The decline in high margin hospital procedures may mean a decline in the number of new patients with high medical debt during the pandemic. Whether the increase in seriously ill hospital patients as a result of contagion from the novel coronavirus will fill that gap depends on whether the federal government, which is currently required to pay for diagnostic testing, steps in to pay for care as well. Health providers are required to accept payments by government entities such as Medicaid and Medicare as payment in full, leaving patients with no medical debt. The pandemic has up-ended assumptions underlying repayment of the very high levels of debt PE firms routinely load on companies they own. In healthcare, the struggle to meet debt obligations can be expected to have especially severe effects on liquidity and even solvency.

[1] Bogoslaw, D. 2008. “Private Equity’s Year from Hell,” BusinessWeek, December 4. (accessed August 2, 2012); PE Hub Blog. 2009. “The Final List: 49 PE-Backed Bankruptcies in 2008,” PE Hub Blog. (accessed August 2, 2012)

[2] Eileen Appelbaum and Rosemary Batt. 2019. “Private Equity Tries to Protect Another Profit Center.” The American Prospect. September 9. Eileen Appelbaum and Rosemary Batt. 2019. “Private Equity and Surprise Medical Billing: How Investor-owned Physician Practices Are Driving up Healthcare Costs.” Institute for New Economic Thinking. September 4.

[3] Joseph Stiglitz. 2019. “It’s Time for Congress to Do Something about the Economic Mess That Private-Equity Giants Have Created,” Business Insider. December 7.

The post Coronavirus and the Implications of Private Equity Buyouts in Healthcare appeared first on Center for Economic and Policy Research.

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How not to lose your mind in the Covid-19 age



here are as many responses to the Covid-19 pandemic as there are people to respond. Some have of us have children to home-school. Some of us have elderly relatives to worry about; some of us are the elderly relatives in question. Some of us have never been busier; others have already lost their jobs.

One experience is common, however: wherever the virus has started to spread, life is changing radically for almost everyone. It’s a strange and anxious time, and some of the anxiety is inevitable. For many people, however, much of the stress can be soothed with – if you will pardon the phrase – one weird trick.

First, a diagnosis. Most of us, consciously or not, have a long list of things to do. At the virus and the lockdowns have spread, many of the items on the to-do list have simply evaporated. At the same time, a swarm of new tasks have appeared, multiplying by the day: everything from the small-yet-unfamiliar (“get toilet paper” and “claim refund on cancelled holiday”) to the huge-and-intimidating (“organise an inspiring home-school curriculum” or “find a new job”).

The change is so fast and comprehensive that for most of us it is unprecedented. Even a divorce or an international relocation is more gradual. The death of a spouse might be the only experience that comes close. No wonder that even those of us who are safe and well and feel loved and financially secure find ourselves reeling at the scale of it all.

To the extent that the problem is that the to-do list is unrecognisable, the solution is oddly simple: get the to-list back in order. Here’s how.

Get a piece of paper. Make a list of all the projects that are on your mind. David Allen, author of the cult productivity manual Getting Things Done, defines a project as “any multistep outcome that can be completed within a year”. So, yes: anything from trying to source your weekly groceries to publishing a book.

That list should have three kinds of projects on it.

First, there are the old projects that make no sense in the new world. For those that can be mothballed until next year, write them down and file them away. Others will disappear forever. Say your goodbyes. Some part of your subconscious may have been clinging on, and I’m going to guess that ten seconds of acknowledging that the project has been obliterated will save on a vague sense of unease in the long run.

Second, there are the existing projects, some of which have become more complicated in the mid-pandemic world. Things that you might previously have done on automatic may now require a little thought. Again, a few moments with a pen and paper will often tell you all you need to know: what’s changed? What do I now need to do? What, specifically, is my next action? Write it down.

Third, there are brand new projects. For me, for example, I need to rewrite the introduction to my forthcoming book (‘How To Make The World Add Up, since you were wondering). It’s going to seem mighty strange without coronavirus references in it. Many of us need to devote more than a little attention to the sudden appearance of our children at home. Some of us need to hunt for new work; others, for a better home-office set-up. Many of us are now volunteering to look after vulnerable neighbours.  In each case, the drill is the same: sketch out the project, ask yourself what the very next step is, and write it down.

Occasionally, you may encounter something that’s on your mind – the fate of western civilisation, for example, or the fact that the health service desperately needs more ventilators and more protective equipment. For my family, it’s an elderly relative, suffering from dementia, in a locked-down nursing home. We can’t visit him. He can’t communicate on the phone or comprehend a video chat. There is, for now, literally nothing we can do but wait and hope. Acknowledging that fact – that there is no action to be taken – is itself a useful step.

I won’t pretend that in this frightening time, working through your to do list in a systematic way will resolve all anxieties. It won’t. But you may be surprised at how much mental energy it saves – and at the feeling of relief as all these confusing and barely-acknowledged new responsibilities take shape and feel more under your control.

Or so it seems to me. Good luck, and keep safe.


Oh – and in case it wasn’t obvious, this week’s Book of the Week is David Allen’s superb Getting Things Done.

My NEW book The Next Fifty Things That Made the Modern Economy is out in the UK in May and available to pre-order; please consider doing so online or at your local bookshop – pre-orders help other people find the book and are a huge help.

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Guest Contribution: “Banks on the Brink”



Today we are fortunate to be able to present a guest contribution written by Mark Copelovitch  (University of Wisconsin – Madison) and David Singer (MIT).

“The peculiar essence of our financial system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.” –Walter Bagehot (1873), Lombard Street: A Description of the Money Market, pp.158-9.

Why do banking crises occur? In our new book, Banks on the Brink: Global Capital Securities Markets, and the Political Roots of Financial Crises, we seek to understand why some countries are more prone to banking crises than other countries or at different times.

At the simplest level, banks collapse because customers lose trust in them. Trust is ubiquitous in the financial system. Banks trust that customers will repay their loans. Depositors trust that banks will manage their money carefully. And banks trust other banks to provide liquidity and to remain standing day after day. But as Walter Bagehot noted in his famed account of London’s 1866 financial panic, trust in the financial system can erode from “hidden causes.” When trust is weakened, even seemingly small accidents—like the collapse of London bank Overend, Gurney, and Company, which triggered the 1866 panic—can cause systemic financial crises.

The details of individual banking crises vary, but rarely does trust in the banking system evaporate without due cause.  In the Panic of 1907, banks collapsed because they were complicit in speculation and market manipulation that led to massive financial losses. During the Asian financial crisis of the late 1990s, the trigger for the collapse of Thai banks was speculative lending to real estate developers, which led to a boom and bust in the real estate market. And in 2008, after a decade of easy mortgages to borrowers with shaky credit histories and a growing bubble in the real estate market, investors grew fearful that banks and holders of mortgage-backed securities might never get their money back.

Our book highlights two key triggers of banking crises. The first, levels of foreign capital inflows, sets the stage for potential distortions in the financial system. Large capital inflows have been found to be a consistent correlate of banking crises. Indeed, many scholars believe that the malignancy of global capital flows is the most likely culprit behind banking crises.  In Lost Decades, their analysis of the Great Recession, Chinn and Frieden (2011) point to the enduring prevalence of the capital flow cycle, in which “capital floods into a country, stimulates an economic boom, encourages high-flying financial and other activities, and eventually culminates in a crash.” They note that many previous crises fit this pattern, including the Mexican and Asian crises in the 1990s, and dozens of others.  Reinhart and Rogoff, in this This Time is Different (2009), suggest that the pattern has deep historical roots. One of their key findings, backed by data covering 800 years of financial crises, is that large current account deficits, asset price bubbles, and excessive sovereign borrowing are common precursors of crises across space and time.  Moreover, bank failures were relatively rare during the Bretton Woods monetary system from the end of World War II to the early 1970s, when governments enacted strict controls on capital movements (Helleiner 1994). This overall finding—that foreign capital opens up a Pandora’s Box of financial distortions—now has the status of conventional wisdom in academic and policy circles.

The potential dangers of capital inflows are real. But existing research has failed to emphasize that foreign capital is not always destabilizing for the banking system. For every instance of a banking crisis preceded by large capital inflows, there are countless examples where inflows are harmlessly—and even productively— channeled throughout the national financial system.  For example, while the U.K. and the U.S. both experienced large current account deficits in the years preceding the Great Recession. Australia and New Zealand also experienced substantial current account deficits, but their banking systems escaped relatively unscathed.

Why do capital inflows lead to banking crises in some cases but not in others? To explain this, we focus on a second variable: national financial market structure. We argue that the substantial variation in the relative prominence of banks versus securities markets (Figure 1) determines whether capital inflows are channeled safely and productively through the national economy, or whether they instead cause banks to take on excessive risks and increase the likelihood of a financial crisis.  Banks often sit alongside other financial institutions, including stock and bond markets, which provide alternative sources of financing for borrowers and alternative investments for savers. When banks are conservative because of the relative absence of competition for financial intermediation, foreign capital can be safely channeled into the system without causing bank instability. On the other hand, when banks sit alongside viable securities markets, capital inflows exacerbate banks’ risk taking and increase the probability of a crisis.

Figure 1: Market/bank ratio, OECD countries, average, 1990-2011

Source: World Bank Global Financial Development Database, calculated as the ratio of stock market trading volume to total bank lending

To test our argument, we analyze data from the 1970s through the early 21st century for most of the world’s developed economies. Figure 2 illustrates the core result of our statistical analysis: capital inflows are only correlated with banking crises under certain conditions – namely, when they flow into a financial system in which commercial banks compete alongside large and highly-developed securities markets.

Figure 2: Average Conditional Marginal Effect of Gross Portfolio Capital Inflows on Probability of a Banking Crisis, by Market/Bank Ratio (World Bank banking crisis classification), 1970-2011

Coefficient on change in gross portfolio inflows (%  of trend GDP, 5-year moving average)

In this book, we not only explore the determinants of banking crises, we also explore how capital inflows and financial market structure interact to affect banks’ risk taking. The conventional wisdom linking capital inflows to crises emphasizes distortions in the allocation of capital as it is channeled through banks and other intermediaries (Portes 2009).  The question is precisely how this plays out and which distortions are most salient.  Some scholars find a clear link between capital inflows and the volume of credit.  For example, Schularick et. al. (2012), in their groundbreaking work on the long-term patterns of financial instability in industrialized countries, find that 1) domestic credit growth is the single most important determinant of banking crises; and 2) capital inflows, as measured by current account deficits, go hand-in-hand with credit booms, especially in the post-Bretton Woods era.  In contrast, other scholars, such as Amri et. al. (2016), find only a weak relationship between capital inflows and domestic credit growth and notes that this connection is diminishing over the last two decades.

If capital inflows lead to banking crises by triggering changes in the volume of domestic lending, then we should find a similar conditional, interactive relationship between capital inflows, financial market structure, and credit growth as we did with banking crises.  However, we find no such relationship – either unconditionally or conditionally – between capital inflows and the growth rate of domestic bank credit.  While capital inflows are conditionally correlated with banking crises, the relationship does not appear to operate through a simple increase in the volume of bank loans.  Rather, credit booms appear to be a separate channel of financial instability from the one we identify in our analysis.

In contrast, we do find evidence that capital inflows influence the propensity of banks to take on greater risk, through a reduction in capital cushions and/or the assumption of greater insolvency risk – and that this varies depending on a country’s domestic financial market structure. In other words, capital inflows – in financial systems where banks complete alongside large securities markets – affect the quality of bank lending and the composition of bank balance sheets.

Figure 3 illustrates this second core result. It shows the conditional relationship between capital inflows, market structure, and national level averages of Tier 1 commercial bank capital.  These results strongly suggest that capital inflows trigger banking crises not because they cause credit booms (surges in the volume of bank lending), but because they lead banks to reduce their capital holdings and lend to more risky customers.  This decline in the quality of banks’ loan portfolios, rather than an increase in the number and amount of loans, appears to be the “smoking gun” linking capital inflows to banking crises in industrialized countries.

 Figure 3: Average Conditional Marginal Effect of Gross Portfolio Inflows (% trend GDP) on Tier 1 Commercial Bank Capital Ratio, by Market/Bank Ratio

Coefficient on change in gross portfolio inflows (%  of trend GDP)

The political roots of financial market structure

While our statistical analysis shows that financial market structure mediates the effects of foreign capital inflows, it cannot explain how such variation in market structure developed in the first place. To resolve this puzzle, we turn to historical analysis, zeroing in on the political decisions that shape the structure of financial markets that make certain countries especially vulnerable to banking crises. Through detailed historical case studies of Canada and Germany, Banks on the Brink shows how seemingly innocuous political decisions about financial rules can accumulate over decades and solidify a country’s financial market structure for generations.

In our case study of Canada, we show that the country’s remarkable history of bank stability has been attributable in part to its equally remarkable fragmented and underdeveloped stock markets. The Canadian Constitution granted the national government the sole authority to regulate the banking industry, but authority over stock markets was relegated to the provinces. During the economic crisis of the early 1930s, while the U.S. government seized the opportunity to create a national securities regulator and to minimize the role of state regulatory agencies, Canada made few changes to its regulatory system. The government took no steps to create a national regulator, instead reaffirming the authority of the provinces to supervise their stock exchanges in accordance with their particular needs. To this day, Canada is the only industrialized country without a national securities regulator. We argue that the country’s underdeveloped securities markets have had a salutary effect on its banks, which have been successful in channeling foreign capital to borrowers over the last four decades without taking on undue risk.

Like Canada, Germany has a long history of bank stability, but it has recently taken a dangerous turn. Our case study highlights how policy decisions in the aftermath of two major financial crises—the Panic of 1873 and the crisis of 1931—arrested the development of German securities markets and solidified a heavily bank-centric financial system. Interest-group and party politics, rising nationalism and anti-Semitism in the late 19th century, and the Nazis’ ascendance to power in the 1930s all conspired to hobble the development of German stock markets prior to World War II, allowing banks to engage in long-term conservative lending with “patient capital” throughout the postwar era until the 1980s. In recent years, however, financial competitors from within and outside Germany have prompted the large German banks to seek alternative sources of revenue. Deutsche Bank, Commerzbank, and other large banks have become champions of Finanzplatz Deutschland, a single large securities market designed to compete with New York and London. As this market has developed, the conservative bias of German banks has eroded, and many required emergency bailouts in the early 21st century.

Key implications

Banks on the Brink shows that politics is the root cause of financial crises, but not in the way that many observers might imagine. Bankers themselves have political preferences and may express them publicly, and some banks lobby for favorable public policies and donate to political campaigns and political action committees. But at a deeper level, banks are embedded in financial markets, which themselves reflect an accumulation of government choices. Banks today operate in an environment shaped by these political choices, some of which make banks more resilient, others of which make them more prone to crisis. This variation, across space and time, explains why some countries find themselves more vulnerable to banking crises and the dangers of foreign capital inflows than others.

These findings have key policy implications for how to minimize the risk of banking crises in the U.S. and elsewhere. In light of the slow-moving nature of financial market structure, any policy proposal to fundamentally alter the shape and depth of financial markets will likely be dead on arrival. Proposals to re-introduce Glass-Steagall-type regulations which separate commercial and investment banking might be episodically popular in countries like the U.S., but as our evidence suggests, they would fail to address the underlying reasons for banks’ excessive risk taking. We also argue against capital controls. Instead, we suggest that regulators should focus their efforts are tightening bank capital requirements, especially in financial systems with prominent or growing securities markets.  Governments are unlikely to be able or willing to fundamentally alter the structure of domestic financial markets in the short- or medium-term. But they can ensure that financial institutions act more prudently, especially when foreign capital inflows flood into the country and the temptation for  banks to engage in more risky behavior is greatest.



This post written by Mark Copelovitch and David Singer.

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Quotation of the Day…



… is this March 21st, 2020, tweet from Thomas Sowell:

It is so easy to be wrong – and to persist in being wrong – when the costs of being wrong are paid by others.

DBx: Indisputably true, both as a matter of logic and as a proposition that consistently succeeds at explaining a great deal of human history.

Note that Sowell’s point is general. Those who are convinced that today’s government-engineered lock-down of much economic activity is appropriate can nod their heads approvingly at the thought that those who are convinced of the opposite fail to account adequately for the costs that would be paid by others were this lock-down less draconian. Ditto the other way ’round: those opposed to this lock-down nod their heads approvingly at what they take to be Sowell’s explanation of why government officials seem now to be so glibly and irresponsibly imposing massive economic costs on hundreds of millions of strangers.

But whatever your position on the lock-down – whether you think it to be worth its gargantuan costs or not worth these costs – you cannot fail to recognize the deep dangers that lurk within any system that allows a handful of people to act in ways that impose massive costs on others.

My own sense is that the benefits of this lock-down are not worth their costs. (And, by the way, I do not reckon as costs only – or even chiefly – financial flows, such as lost profits, and the monetary values of foregone goods and services. Among the many kinds of costs of this lock-down are worse-than-otherwise health in the future, and the innumerable problems inevitably to be created by governments with yet more discretionary powers.) Yet even if I am mistaken – and perhaps I am (I say sincerely) – we should all be deeply suspicious of discretionary power exercised by government officials – power the costs of the exercise of which are borne almost wholly by third parties.

The grade-school fiction – one embraced also by many PhD-sporting intellectuals – is that majority-rule democracy is sufficient to ensure that all decisions made by government officials in democratic nations are without any such negative externalities, that is, without any undue ill-consequences imposed on third-parties. “We the people” make these decisions ourselves through our elected representatives and the assistants that they hire to help them. Problem avoided!

Anyone who believes in this above account of democracy is too naive for words. He or she is wholly ignorant of even the most basic principles of public-choice economics – an ignorance, note, that itself imposes negative consequences on third-parties by encouraging the naive to impose the costs of political superstitions and of the resulting dangerous policy-making regimes on their fellow citizens. Such people should read Buchanan, Tullock, Downs, Olson, SchumpeterArrow, Stigler, Wagner, Niskanen, Higgs, Holcombe, Yandle, Brennan & Lomasky, Caplan, Lee, Simmons, Munger, and Achen & Bartels, among others. Oh, and do read also Sowell’s own great magnum opus.

The post Quotation of the Day… appeared first on Cafe Hayek.

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