Good and Bad Banking on Europe’s Periphery: Pathways to Catching up and Falling behind

Banks can be both a blessings and a curse for states. Banks can lay the foundations for economic power. But they can also cause economic catastrophe. Banks have been instrumental to state formation and economic development. But that does not mean they have always been effective in such undertakings. Indeed, there is enormous variation in the degree to which banking systems have provided adequate credit to an economy, funded innovation, ensured financial stability, insulated countries against external economic shocks or provided countercyclical lending in downturns. Banking sectors’ fragilities were clearly on display during the US financial crisis and after. Nowhere was variation more evident than on Europe’s periphery—East and South.

We argue that bank performance—measured in terms of credit provision and financial stability—depends on the particular mix of social purpose and market discipline - underpinning banks’ behavior. Economic nationalism centered on striving for policy autonomy imbues banks with political goals, including serving the national economy. Economic nationalism is therefore the source of social purpose. But we  argue that for optimal bank performance, economic nationalism and social purpose must be constrained. Market discipline in tension with social purpose prevents banks from engaging in excesses—including related-party lending or imprudent risk assumption. We find that countries with elements of nationalism in combination with robust political competition are most likely to have domestic banks that provide both sufficient credit  financial stability. But we also find that this optimal mix of social purpose and market authority had by 2016 become increasingly challenging and rare in Europe’s peripheral states.