Saturday, February 16, 2008

Bank Failures of the Great Depression

Huh, pretty interesting (or how timely) that the Fed is publishing a research paper on bank failures during the Great Depression. Text in bold is my emphasis. The original research paper can be found at the Fed site. From the WSJ economics blog:

In case you were not aware Ben Bernanke’s specialty during his academic career was the Great Depression. A collection of his academic articles can be found in his book entitled Essays on the Great Depression. The first article in the book is a good summary of the macroeconomics of the Great Depression. What amazes me is what we don’t know and understand about the Great Depression.

The Great Depression may be ancient history but interest in the subject is enjoying a revival, including at the Federal Reserve, now chaired by self-described “Great Depression buff” Ben Bernanke.

A new research paper by staff economist Mark Carlson tackles a seemingly esoteric topic that could have useful lessons for the current crisis. In his working paper, recently posted on the Fed’s Web site, he investigates whether some of the thousands of banks that failed in the Great Depression could have survived if only they hadn’t been sucked down in a panic.

Previous research has found that banks that failed during the Depression started out weaker than banks that survived, suggesting a lot of the bank failures may have been unavoidable. But Mr. Carlson finds that “many of the banks that failed during the panics appear to have been at least as financially sound as banks that were able to use alternative resolution strategies,” such as merging, or suspending and recapitalizing.

When a failed bank was liquidated, its “assets [were] 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… 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.”

Mr. Carlson defines a panic as a period in which statewide bank failures are relatively elevated and there is “some clustering of failure-at least three failures or suspensions in the same county or more than one county with at least two suspensions or failures.” Using that method he finds 20 panic periods from 1930 to 1933 in the 21 states for which he has data. Almost a quarter of the more than 6,000 banks in those states failed in that period, and about a fifth of those failures occurred during panics. Comparing the banks that failed during panics to banks that found some other way to survive he found that the two groups were of roughly similar financial health. The reason the first group failed and the second group didn’t was that they were swept under by the panic. “The financial turbulence associated with the panics may have resulted in some banks being placed in receiverships and liquidated instead of being able to resolve their troubles less disruptively.” These banks represented 30% of all failed banks’ assets -– a sizable portion.

If any of this sounds familiar to Bernanke watchers, it’s because these issues were central to his own groundbreaking research on the Great Depression, which is duly cited in Mr. Carlson’s paper.

Mr. Carlson draws no explicit lessons from his research for the present, but it’s easy to imagine some. Despite their woes, banks are reasonably well capitalized today and a panic seems pretty unlikely, especially with federal deposit insurance covering most of depositors’ money. But large swathes of the financial system are outside the deposit insurance safety net – some of it in other parts of banking conglomerates, some of it outside the banks altogether, in mortgage companies, hedge funds, and asset-backed securitization pools. Much like a run on a bank, a generalized investor flight from such institutions could cause some to fail, even if their assets were fundamentally sound.

In fact, they don’t even have to fail to affect the economy: they only have to see their capital impaired, or stretched, enough to shut down further lending. That could cause further economic weakness, which feeds back into greater stress on the institutions. Mr. Bernanke and his colleagues have made ever increasing reference to such negative feedback loops. (Actually, they are technically positive feedback loops, in that the initial stress produces responses in the same direction; in a negative feedback loop, the initial stress is followed by a response in the opposite direction, causing it to rapidly peter out. But that’s semantics.)

The newfound urgency to Fed rate cuts is driven largely by a belief that, if timely and aggressive enough, such cuts can short-circuit such a feedback loop, and preventing far greater, and unnecessary, economic damage. — Greg Ip

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