A new paper published by the National Bureau of Economic Research examines how the structure and interconnectedness of the financial system on the eve of the Great Depression played a role in financial instability and bank failure rates:
We employ a unique hand-collected dataset and a novel methodology to examine systemic risk before and after the largest U.S. banking crisis of the 20th century. Our systemic risk measure captures both the credit risk of an individual bank as well as a bank’s position in the network. We construct linkages between all U.S. commercial banks in 1929 and 1934 so that we can measure how predisposed the entire network was to risk, where risk was concentrated, and how the failure of more than 9,000 banks during the Great Depression altered risk in the network. We find that the pyramid structure of the commercial banking system (i.e., the network’s topology) created more inherent fragility, but systemic risk was nevertheless fairly dispersed throughout banks in 1929, with the top 20 banks contributing roughly 18% of total systemic risk. The massive banking crisis that occurred between 1930–33 raised systemic risk per bank by 33% and increased the riskiness of the very largest banks in the system. We use Bayesian methods to demonstrate that when network measures, such as eigenvector centrality and a bank’s systemic risk contribution, are combined with balance sheet data capturing ex ante bank default risk, they strongly predict bank survivorship in 1934.
For a bank failure to turn into a financial crisis, instead of remaining localized to a particular area or set of banks, there must be a “contagion” effect, where the failure of even a few banks in an interconnected financial system sets off a chain reaction of default. But, as with an actual disease, how the contagion spreads depends on the “topology” of the financial system.
The structure of the 1929 financial system resembled a pyramid in that a small number of large banks located in financial centers, such as New York and Chicago, had a great many connections to banks across the country, while the rest had relatively few linkages.
By comparing the fragility of the pyramid structure with a more randomly structured network, the authors find that “all else equal, contagion will spread faster in the pyramid network because its connections are more concentrated.” The paper also found that the failure of over 9,000 banks after 1929 led to greater concentration of risk in larger, surviving banks.
From a macroprudential standpoint, this would lend some support to the view that big banks should be broken up. But the topology of the financial system isn’t everything–the capital structure and portfolio of a given bank also influences its odds of survivorship. “Centrally-located banks in the network had higher predicted probability of failure, but the most systemically important banks…entered the Great Depression relatively healthy–with below average credit risk” find the authors. “They flexed but, in general, did not break (fail).”
Government intervention also had a role to play in increasing survivorship. The Reconstruction Finance Corporation (RFC) offered collateralized loans to struggling banks, contributing to the counterintuitive finding that a bank with a higher individual contribution to systemic risk increased the probability of survival. Smaller banks weren’t so lucky since RFC targeted loans with banks’ contributions to systemic risk in mind.
There are definite benefits to increased financial interconnectedness in the form of greater access to credit and other financial services, but this comes at the cost of increasing the risk of contagion. Balancing the benefits and costs of such a structure should come from regulations that ensure banks are sufficiently capitalized to weather a downturn and prevent contagion from spreading.
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