Lambert here: A history lesson. But those who don’t learn from history…
By Kris James Mitchener, Robert and Susan Finocchio Professor of Economics at the Leavey School of Business, Santa Clara University; Research Fellow, CEPR, and Gary Richardson, Associate Professor in Economics, UC Irvine. Originally published at VoxEU.
The Global Crisis emphasised the fragility of international financial networks. Despite this, there has been little historical research into how networks propagate financial shocks. This column explores how interbank networks transmitted liquidity shocks through the US banking system during the Great Depression. During banking panics, the pyramided-structure of reserves forced troubled banks to reduce lending, thus amplifying the decline in investment spending.
How financial networks propagate shocks and magnify recessions is of interest to both scholars and policymakers. The financial crisis of 2007-8 convinced many observers that financial networks were fragile, and while reforms are underway, much remains to be learned about how and why connections between financial firms matter for the macroeconomy. Indeed, the complexity and sheer number of linkages has made it particularly challenging to formulate empirical estimates of their role in amplifying downturns.
Economic theory suggests many channels through which networks may transmit shocks (Allen and Gale 2000, Cabellero and Simesek 2013) and empirical research has provided some evidence of contagious failures flowing through interbank markets, particularly for the recent financial crisis in the US and Europe (Puhr et al. 2012, Fricke and Lux 2012). History should have a lot to say about the role of networks in contributing to the severity of financial crises, but it is a surprisingly lightly studied aspect of earlier periods of financial turmoil – even for well-researched episodes such as the Great Depression. This lacuna exists despite the fact that financial networks of the past may be simpler in structure, thus making it somewhat easier to identify empirically how aggregate variables, such as lending, were affected when linkages were disrupted.
In a recent paper, we document how the interbank network transmitted liquidity shocks through the US banking system and how the transmission of these shocks amplified the contraction in real economic activity during the Great Depression (Mitchener and Richardson 2016). The paper contributes to the growing literature on financial networks and the real economy, illuminating both a mechanism for transmission (interbank deposits) as well as a source of amplification (balance-sheet effects). It also introduces an additional channel through which banking distress deepened the Great Depression and complements existing research on how bank distress during the Great Depression influenced the real economy.
We describe how a pyramid-like structure of interbank deposits developed in the 19th century, how the founding of the Fed altered the holdings of these deposits, and how this structure then influenced real economic activity during periods of severe distress, such as banking panics (Mitchener and Richardson 2016). The interbank network that existed on the eve of the Great Depression linked large money centre banks in New York and Chicago to tens of thousands of smaller rural banks throughout the US. The money centre banks served as correspondents holding deposits from institutions in the countryside. Interbank balances exposed correspondent banks to shocks afflicting banks in the hinterland. Interbank deposits were a liquid source of funds that could be deployed to meet sudden demands by depositors to convert claims to cash, and the removal of these deposits from correspondent banks peaked during periods that contemporary commentators described as – and that our detailed statistical analysis of bank suspensions confirms were – banking panics. Although the pyramided system of interbank deposits could handle idiosyncratic bank runs, when runs clustered in time and space (i.e. when panics occurred) the system became overwhelmed in the sense that banks higher up the pyramid were forced to adjust to these changes in liabilities by changing their assets (i.e. lending).
We use the timing and location of these panics to statistically identify the causal relationship between panics, deposit withdrawals, and the decline in lending that occurred in banks in reserve and central reserve cities throughout the US. During periods identified as panics, withdrawals of interbank deposits forced correspondent banks to reduce lending to businesses. These interbank outflows led to a substantial decline in aggregate lending, equal to approximately 15% of the total decline in commercial bank lending in the US, from the peak in 1929 to the trough in 1933.
Ironically, the Federal Reserve System had been created with the purpose of preventing crises such as those that had regularly plagued the banking system in the 19th century. We help to explain why the Fed failed to fulfil this basic responsibility. Because the Fed failed to convince roughly half of all commercial banks to join the system, a pyramided-structure of reserves persisted into the third decade of the 20th century and created a channel through which the interbank deposit could influence real economic activity. In theory, pyramided reserves could have been deployed to help troubled banks, but during the banking panics of the 1930s, just as in the panics of the late 19th century, the total size of these withdrawals overwhelmed correspondent banks, leaving those banks with the choice of either saving themselves, contracting on the asset side of their balance sheets, or borrowing from the Fed. With the Fed unable or unwilling to provide sufficient liquidity to support distressed correspondent banks, they were forced to react to interbank outflows by reducing lending, thus amplifying the decline in investment spending. Although the mechanism is new, our results corroborate other studies on the Depression, which emphasise how banking distress reduced loan supply (Bernanke 1983, Calomiris and Mason 2003b).
What might have alleviated this problem? One solution would have been for the Federal Reserve to extend sufficient liquidity to the entire financial system. The Fed could have done this by lending funds to banks in reserve centres. In turn, those banks could have loaned funds to their interbank clients. To do this, banks in reserve centres would have had to accept as collateral loans originated by non-member banks. Banks in reserve centres would, in turn, need to use those assets as collateral at the Federal Reserve’s discount window. However, leaders of the Federal Reserve disagreed about the efficacy and legality of such action.
Another potential solution would have been to compel all commercial banks to join the Federal Reserve System and require all commercial banks to hold their reserves at a Federal Reserve Bank. Due to powerful political lobbies representing state and local bankers, however, Congress was unwilling to contemplate legislation that would have effected such changes. Had they done so, the pyramid structure of required reserves would have ceased to exist, and the interbank amplifier, as defined here, would have been dramatically diminished. That said, given the inaction of some Federal Reserve Banks during the 1930s, had such changes taken place, they may have magnified banking distress as more banks would have depended on obtaining funds through Federal Reserve Banks that adhered to the real bills doctrine. As we show, the costs of the pyramid in terms of a contraction in lending were substantial, but banks still met some of their short-term needs through this structure during the turbulent periods of banking distress.
Allen, F and D Gale (2000) “Financial contagion,” Journal of Political Economy 108:1-33.
Bernanke, B S (1983) “Nonmonetary effects of the financial crisis in the propagation of the Great Depression”, American Economic Review, 73(3): 257-276.
Caballero, R J and A Simsek (2013) “Fire sales in a model of complexity”, The Journal of Finance, 68(6): 2549-2587.
Calomiris, C W and J R Mason (2003b) “Consequences of bank distress during the Great Depression”, American Economic Review, 93: 937-47.
Fricke, D and T Lux (2012) “Core-periphery structure in the overnight money market: Evidence from the e-MID trading platform”, Kiel Institute for the World Economy, Working Paper No 1759.
Mitchener, K and G Richardson (2016) “Networked contagion and interbank amplification during the Great Depression”, CEPR Discussion Paper 11164.
Puhr, C, R Seliger and M Sigmund (2012) “Contagiousness and vulnerability in the Austrian interbank market”, OeNB Financial Stability Report, No 24, Oesterreichische Nationalbank.