US Bank Panics in the Great Depression

The WSJ Economics Blog highlighted a paper by Mark Carlson of the Fed, titled Alternatives for Distressed Banks and the Panics of the Great Depression.

I must say that I don’t consider the conclusions too earth-shattering, but it’s always good to have hard data! The penultimate and conclusive sections read as follows:

One potential reason that restructuring may have been more difficult for banks that failed during panics is that the surge in the number of failing banks during panics increased the competition for new capital. It seems quite reasonable that, at least in the short run, the pool of resources available to investors to recapitalize banks is fixed. As the number of troubled institutions competing for those resources rose, only a small fraction might have been able to obtain them. Thus, even though some banks might have been able to attract capital during ordinary times, there were simply too many banks seeking that capital during panics.

A second reason that panics may have inhibited the ability of banks to pursue alternative resolution strategies is that the number of banks in trouble during panics may have made rescuing the banks more expensive or difficult. Allen and Gale (2000) show how interbank claims can cause losses to spread across banks. Diamond Rajan (2005) present a model in which illiquidity problems at one bank can reduce the liquidity of the banking system and cause problems for other banks. In these models the more banks affected in the initial state, the greater will be the problems for the other banks. Ferderer (2006) finds evidence that market liquidity did decline at times during the Depression. Donaldson (1992) also illustrates how that value of a bank can fall as the number of other banks in distress increases.

A third potential for the difficulty in attracting capital in crises might be an increased difficulty in valuing banks during a panic. Wilson, Sylla, and Jones (1990) noted that asset price volatility increases during panics. If investors had a more difficult time than usual valuing the bank, especially with risks likely tilted to the downside, they may not have been as willing to assist in restructuring the bank.

All three of these reasons could potentially contribute to a reduction in the ability of banks to recapitalize after suspending or to merge with another bank during a panic. The data used in this paper does not allow us to explore which, if any, of these reasons appears particularly important. This area may be fruitful ground for further research.

Section 5. Conclusion

The empirical literature on banking panics finds that banks that failed during panics were generally economically weaker than the ones that survived. The analysis here comes to a similar conclusion, but argues that this comparison provides an incomplete picture of the effects of panics on the banking system. Banks had alternatives to failing during regular times; they could either suspend and reorganize or merge with other banks. This study examines whether banks that failed during panics might, had the panic not occurred, have been able to pursue these other options. Through a series of comparisons, I find evidence that the balance sheets of banks that failed during panics were at least as strong as those of banks that were able to pursue alternative resolution strategies. These findings suggest that the panics may have played a role in preventing banks from suspending and reorganizing or from finding other banks to merge with, possibly due to the increase in the number of problem banks and uncertainty in pricing financial assets during panics.

The period of liquidation following bank failure caused assets to be taken out of the banking system and frozen for extended periods. During a bank merger, the assets stay in the banking system continuously. For banks that suspended temporarily, the median length of suspension in this sample was about 5 months. By comparison, Anari, Kolari, and Mason (2005) find that the average length of liquidation of a bank that failed in the early 1930s was about 6 years. The loss of the bank expertise and the freezing of bank assets and deposits have been found to have had negative effects on output (Bernanke 1983, Anari, Kolari, and Mason 2005}. Thus, to the extent that the panics prevented banks from pursuing less disruptive resolution strategies, then the panics of the early 1930s may well have played a role in prolonging and deepening the Great Depression.

One Response to “US Bank Panics in the Great Depression”

  1. […] is far too rigorous a central banker to bail out an insolvent institution. See, for example, US Bank Panics in the Great Depression, with particular attention to the references in the last paragraph of the conclusion. Also, see The […]

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