Banking crises follow a similar pattern throughout history. Banks make leveraged investments in the form of loans to businesses or individuals (in the latter case, usually homeowners), the borrowers are unable to pay them back, and a vicious cycle of default ensues.
But there is a difference between a banking crisis and a more general decline in economic output (i.e. a recession). A new paper from the National Bureau of Economic Research outlines how the beginning of the Great Depression didn’t start with a banking crisis, but evolved into one due to inconsistencies in the way government support for struggling banks was doled out compared to previous banking crises:
Modern financial crises are difficult to explain because they do not always involve bank runs, or the bank runs occur late. For this reason, the first year of the Great Depression, 1930, has remained a puzzle. Industrial production dropped by 20.8 percent despite no nationwide bank run. Using cross-sectional variation in external finance dependence, we demonstrate that banks’ decision to not use the discount window and instead cut back lending and invest in safe assets can account for the majority of this decline. In effect, the banks ran on themselves before the crisis became evident.
The reason a banking crisis, as traditionally understood, didn’t cause the Great Depression, as the authors put it, “can be explained by bank actions: the reduction in loans and purchase of safe assets. We argue that banks realized the severity of economic conditions and, in effect, ran on themselves.”
The 1929 crash injected chaos into the U.S. economy. Households started pinching pennies (especially when it came to the durable goods, the purchase of which U.S. manufacturing depended on). Banks caught on, and accordingly dramatically reduced their lending to businesses.
But there’s one interesting twist to this story. One of the primary roles of the Federal Reserve System is to act as a lender of last resort through the “discount window.” In the event a bank ran into trouble, their local Fed would provide them with discounted loans to keep it afloat, which is why the “Panic of 1920” didn’t turn into a catastrophe, and was thus championed as a victory for the Federal Reserve System.
But banks’ eagerness to take advantage of the discount window is why the Fed introduced the “discount window stigma,” which placed various restrictions and regulations on banks that used the discount window. This stigma, though helpful during the roaring ‘20s, backfired. When banks “ran on themselves” by contracting lending and moving to safer assets, the resultant decline in lending hurt the economy at large.
It was only after banks shifted their assets en masse to safer investments that depositors began to panic, withdrawing assets at large rates and bringing on bank runs of the kind featured in It’s a Wonderful Life.
What’s to be learned from this? On the one hand, it shows evidence that, broadly speaking, “bailouts” can work. Gary Gorton (one of the paper’s co-authors), described bailouts as “a reasonable response” to the too big to fail problem in another paper, and Niskanen’s Anat Admati described herself as “agnostic” on the 2008 bailouts. When a crisis emerges, not using such an option is akin to not calling the fire department when your house is ablaze.
On the other hand, it shows the importance of preemptive macroprudential regulation in the form of greater equity financing requirements to reduce the necessity of banks’ “flight to safety” during a downturn.