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Banking Portfolios and Banking Distress During the Great Depression in the U.S.

Does the amount and kind of banks’ investments influence the banking failure rates in the Great Depression?

Bachelor Thesis 2015 49 Pages

Business economics - Economic and Social History

Excerpt

Table of Content

List of Abbreviations

List of Figures and Tables

1. Introduction

Literature(Review
2. The American Banking System and Its Importance
3. The Financial Crisis
4. Value at Risk

Empirical(Part
5. Dataset
6. Study
7. Conclusion

Reference List

Appendix

List of Abbreviations

illustration not visible in this excerpt

List of Figures and Tables

Table 1 - Banks And Population, by Geographical Divisions, June 30, 1929

Table 2 - Composition of Commercial Banks’ Balance Sheets 1924-1929

Table 3 - Subsections of Commercial Banks’ Assets

Table 4 - States With Highest And Lowest Banking Failure Rates 1929-1933

Table 5 - VaR of Asset Types

Table 6 - Total Assets And Liabilities of The United States 1929

Table 7 - Current Assets And Liabilities of The United States 1929

Table 8 - Percentage Decline of Assets on The State Level

Figure 1 - Regression Analysis of Study Part 1

Figure 2 - Percentage Decline of Assets on The State Level

Acknowledgment

First and foremost I want to thank my supervisor, Professor Mrdjan Mladjan, who has supported me throughout my Bachelor Thesis. His knowledge and continuous assistance made it possible for me to write this paper. He did not only give me the general idea, but also provided me material.

1. Introduction

From 1921 until 1929 the United States experienced rapid and continuous growth, improvements and wealth in the economy without considerable contractions. Although one might think an absence of a recession for over a decade should raise fear, but instead a climate of overconfidence existed (Stiglitz, 2003) and caused a general underestimation of a possible recurrence of a severe depression. Consequently, an outbreak of the depression was more likely (Peicuti, 2014).

From August 1929 onwards, the United States’ financial system suffered the longest and most challenging time ever in its past since a worldwide recession took place and ended in a crisis of global scope, namely the Great Depression. The continuing downturn of the United States did not come to an end until the Banking Holiday in 1933. This time was mainly characterized by a one-third decrease of output, money stock, and prices and therefore was the most serious economic downturn in the United States’ history. There have been other historical periods facing banking crises, but most of them only lasted for a short period of time. Friedman and Schwartz (1963) labelled the deterioration of the United States “The Great Contraction of 1929-1933” and blamed four successive banking crisis for the serious impact on the world’s economy. The Great Depression was affected by extremely large economic as well as social pressure since Gross National Product dropped almost 30 precents, from $190.9 billion to $141.5 billion and unemployment increased by 20 precents in the time period from 1928 to 1933 (Kendrick, 1961). Around 85,000 businesses failed and hundreds of thousands lost their homes. Although there was a short period of recovery after the peak of the Great Depression, the aggregate gross national product could not fully recover again until 1938 (Graham, Hazarika, & Narasimhan, 2011). Even the stock market crashed. The Dow Jones Industrial Average (DJIA) experienced a value decline of four fifths between 1928 and 1932 and the aggregate market value of shares available in the New York Stock Exchange (NYSE) decreased dramatically, from $60 billion to $20 billion in the same time period (Graham, Hazarika, & Narasimhan, 2011). According to this, the years from 1929 until 1933 were a time full of unrest in the country, characterized by impecuniousness, deflation, slight profits, and desperateness in terms of economic wealth and growth. However, most shoring was that a significant number of over 9000 banks failed in the United States from August 1929 until the Banking Holiday in 1933 (Friedman & Schwartz, 1963).

In the meanwhile several researchers, historians, politicians, and other experts tried to comprehensively explain the causes of the Great Depression, but nevertheless it is still one of the largest unresolved mysteries for historians. So far there is no universal explanation provided.

The general structure of the United States’ banking system played an immense role in most of the theories explaining the reasons for the financial crisis and its subsequent banking failures of the Great Depression. Even Grossman (1994) stated that the structure of the banking system as well as the structure of single banks had a great impact on the vulnerability of banks. Therefore, the paper starts with a brief explanation of the American banking system, its importance and the general structure, in order to prove sound previous knowledge to better understand the following theories.

During the financial crisis, starting in August 1929, several depository institutions had to close their doors; in other words only 14,000 out of almost 24,000 were still operating in the banking industry after March 1933. Therefore, one can say that the financial crisis in the United States was mainly characterized by high banking failure rates.

In the third chapter a comprehensive overview of the financial crises during the Great Depression is given, all significant aspects that could have influenced or even triggered the financial crises are explained and defined, and different views of researchers are provided. Due to the fact that the banking failures were of great importance during the financial crisis, provided theories mainly focus on the causes of the banking failures. The financial crisis’ main focus of the Great Depression was on the extraordinary high banking failure rates and therefore the main objective of this paper is to investigate whether it would have been possible to forecast the high failure rates on the basis of the bank’s balance sheets before the Great Depression or not. There are several methods that help to study resources and liabilities of banks. However, the study in this paper mainly focuses on the value at risk measurement, a method to manage market risk.

Therefore, a comprehensive definition, its emergence in connection with the Basel Accords, and different measurement methods are provided.

Due to the fact that the economy has to face financial crises again and again it is time to figure out models that might forecast financial crisis. Therefore, characteristics of former financial crisis have to be analysed in a manner that tell whether it would have been possible to forecast banking failures. In this study it will be investigated whether banks’ balance sheet could be a foundation of such theories. For this reason, the study is subdivided into three major parts.

First of all, it is tested whether investments of banks influence banking failure rates at all. This part is conducted on the state level. Banking failure rates, value of risk of different asset types and the amount invested in a particular asset relative to total assets are set into correlation by means of a regression model. In the second part of the study it is investigated whether banks in the United States were more likely to run illiquid or insolvent during the Great Depression. For that, the value at risk on the country level is calculated, but in contrast to the second part the correlation between different asset types as well as the actual possession of different asset types of all United States’ banks are considered. In order to come to a conclusion, the value at risk is compared to equity and working capital. Last but not least the study examines whether there is a “proportional connection” between banking failure rates and the value of risk, depending on the amount the banks invested in the different asset type. The conclusion will summarize all findings and link it to the literature of the paper.

Literature Review

In this section an overview of current literature is provided, starting with a brief representation of the United States’ banking system, its importance and general structure, and continuing with a detailed elaboration of the financial crisis with special regard to literature on the field of banking failures.

2. The American Banking System and Its Importance

Considering the history of the United States in financial terms, there have been immense up and downs when it comes to banking and credit structures. Especially during 1930 and 1931 several bank failures had an enormous impact on the banking situation as many depositors were exposed to extensive losses, security markets were affected negatively, and the opportunity to guarantee loans, intended for the bank’s customers, shrank. The United States banking system was known and presumed as a consolidated one, since the stability of the credit structure was always guaranteed. However, during 1930 and 1931 financial difficulties arose and population’s perception changed. A trace of anxiety concerning the banking insecurity and a general feeling of suspiciousness emerged. Due to the fact that population’s trust and banks’ high dimension of interdependency were of extreme importance, above-mentioned financial difficulties entailed vast troubles.

In order to gain deeper insights of banking events, to appraise the American banking system when it comes to judgments and get a broad understanding of the banking situation before and during the Great Depression, it is fundamental to provide a brief overview of the American banking systems’ general form as it existed in 1929, not considering the changes and the formation of the Federal Reserve System in its past but only the real nature. Although the banking system, constructed by state and federal regulations, is mostly not considered, it is of great importance in matters of the bank’s ability to bear up any shock.

2.1 General Form of The American Banking System

The American banking system differed clearly from that of other nations as in Western Europe. Banks in the United States were mainly small, independent, had single offices and were at the very most private owned unit banks. In contrast to banking systems of other nations it entailed less large banks with a developed branch systems and more precise national system structures (White, 1983).

“The underlying conception of an independent unit bank is that of a banking institution having its origin and ownership in the local community and deriving its business chiefly from the community’s industrial and commercial activities and from the farming population within its vicinity or trade area, as determined by available transportation facilities. […] Often its officers are the main source of local business counsel and advice, contributing notably to the development of the community’s enterprise” (National Industrial Conference Board, 1932, p. 7)

Banks are deemed as the financial analogue of enterprises with local ownerships and independent managements, and consequently thousands of independent privately owned unit banks existed in the United States. This implied that the ratio, banks relative to the population, had to be quite high. The Continental United States for instance had 20.5 banks for a population of 100,000 in 1929 (Federal Reserve Board, 1929). [Table 1]

Table 1 shows that there was a significant number of banks, under national as well as state character, in contrast to the population. Divided in geographical division one can read off that the ratio was clearly highest for the Western division. This might have been due to its intense agricultural environment.

Although the United States banking system was characterized by unit banks there are some exceptions, as some of the banks had branches. They were mainly represented in medium and large cities. Even though branch banks were more expensive to operate, they had the opportunity to grow larger compared to unit banks (Benston, 2012). Amongst others there was chain and group banking as well. Chain banking means that, in the majority of cases, an individual or sometimes also a group of individuals owns or at the least controls several banks. Group banking has the small but subtle difference that there is not a single or group of individuals owning or controlling diverse banks but a holding company.

In the United State’s banking system banks, including unit, branch, chain, and group banks, could operate in different banking activities. Some worked mainly in the commercial banking business whereat other functions were the saving banking business. Fiduciary functions, even in combination with saving and commercial activities, were in demand as well. Some banks could not assign themselves to a particular type of business since they operated in the saving, commercial, fiduciary and even investment banking. They were called multiple-function banks.

At first sight, it seems like there was no interrelated, coordinated, and well-structured banking system in the United States because of the large number of independent unit banks. However, apart from the fact that all states used the same currency for banking activities there were special banking laws comprising guidelines for the bank’s business executions. These legal codes supported unification in the United States’ banking system although there were no homogenous legal regulations for the whole American banking system.

The most outstanding paragraph was the one referring to the unlike standards of national and state banks. State and national banks mainly differentiate in its size of capital stock, since to qualify operating as a national bank it was required to have a minimum of $25,000 in capital stock (National Industrial Conference Board, 1932).

There also was a significant difference in the quantity of state banks and nation banks present in the United States. In particular there were a whole lot more of state banks. Regulations for national and state banks were different when it comes to banks’ loans, bank capital, investments and reserves. These restrictions should mainly protect the interests of banks’ customers. Laws for national banks were stricter since they were constructed to foster safer working processes than state banks conducted. Amongst others, less rigorous laws entailed that in the majority of cases banks preferred to be characterized as a state bank. As a consequence, the unequal distribution of state and national banks has been occurred.

National banks were subject to regulations stating that the Federal Reserve System (FED) and the Comptroller of the Currency (OCC) had to conduct their supervision and evaluation. The OCC is a United States “department of the treasury that charters, regulates and supervises all national banks and federal savings […] to ensure that national banks and federal savings associations operate in a safe and sound manner” (Comptroller of The Currency, 2015). The FED is deemed as the United State’s central banking system. National banks were bound to be a member of the FED, whereby state banks underlay the state law. However, state banks had the choice to become a member if they wanted and although it was not obligatory for state banks, one third of commercial banks were subscribed (Comptroller of The Currency, 2015).

Examiners and supervisors of non-member state banks were the state banking commission. Their duties were to evaluate if banks’ characteristics of practice accorded with the requirements of state statutes. Members of the FED were also supervised and examined by the Federal Reserve Board as well as by the Federal Reserve Banks. Due to the fact that not all banks in the United States were subject to same banking codes, regulations, and standards, besides of banks being part of the FED, there were various distinctions of supervisory practices. The mentioned regulations and banking codes differed from state to state and consequently the banking system in the United States was divided into geographical sections (Federal Reserve Board, 1929).

3. The Financial Crisis

From 1929 until 1933 the financial crisis had an immense effect on the United State’s economy. Currently, there are two general views explaining circumstances that led to the Great Depression and the subsequent financial crisis in the United States. First of all, the demand driven view, focuses on the macroeconomic effects and states in general that the crisis emerged due to an immense downturn in the real sector. Theories indicate that the Great Depression is caused by a mixture of low asset price, declining consumption, under invesments, and the absence of self-correcting financial markets. According to demand driven theories, the financial crisis is supposed to be a consequence of ongoing events, but does not have a special role in the recession (Keynes, 2011). In contrast, researchers as Friedman & Schwartz (1963) and Wicker (1980, 1996) came up with the monetary view. This view is predicated on the propostion that the beginning of the Great Depression was a normal recession due to the current government policy in conjunction with a decline of the money supply. Thereupon, on the basis of the bad monetary policy and the financial crisis the recession turned into a serious depression. However, literature came to the agreement that both, Federal Reserve activities leading to a varying money supply (monetary approach) as well as the flawed economic structure (demand driven theory) need to be linked to exactly understand the causes of the Great Depression.

A major cause of the financial crisis is the constantly increasing number of debtor that became bankrupted. Lasting decreases in prices, immense reduction in money income, and the fact that debt contracts were issued in nominal terms induced high debt burdens. The heavily increasing ratio, debt services as a fraction of national income (Clark, 1933), did not only cause problems for lenders but also for borrowers. This affected all sectors, some more some less. Farmers, for instance were more affected than house owners or the business sector since low prices for their offerings got farmers into troubles so that they were not able to repay their debt anymore. Not only the prolonged deflation but also high rates of failed financial institutions triggered the financial crisis. During the Great Depression, many financial institutions were exposed to high pressure. Insurance Companies but also for example, mutual saving banks were able to conduct almost normal operations whereas commercial banks had immense problems in surviving. Banks were forced to close in such an extent that in the end of 1933 only 50 percentages of the number in 1929 existed. Even the banks that did not have to close suffered from big losses. As the general structure of the American banking system shows there were a lot of small independent banks, branch banking was mainly forbidden, and due to the competition of member banks’ entry in banking was fairly low. An immense number of banks were not viable anymore and failed. Not only the natural reasons caused banking failures, but also, in addition, financial panics emerged all over the United States and caused banking failures (Bernanke, 1984). Liabilities in the form of fixes price demand deposits and assets in illiquid form did not only increase the vulnerability of banks but also supported banking panics and following illiquidity problems. Banking panics were a drastic problem or even a crucial part of the banking crisis during the Great Depression.

3. 1 Banking Panics and Bank Runs

The definition of banking panics is mostly imprecise since a lot of researchers equalize banking panics with banking failures. There are no explicit definitions provided and therefore different happenings of the United States’ history are assigned to banking panics.

In this paper banking panics are seen as an exogenous shock caused by bank runs. They occur when a huge amount of debt holders suddenly demand cash for their debt claims. In order to talk about banking panics the demand for redemption must be to a certain extent, so that banks either cannot disburse cash anymore or have to “act collectively to avoid suspension of convertibility by issuing clearing-house loan certificates” (Calomiris & Gorton, 1991). This definition requires several additions. If depositors of only one bank demand to redeem debt for cash and the bank will result in illiquidity it will be called a bank run. For a banking panic several banks need to be involved. Even the depositor’s desires for cash need emerge suddenly as well as the volume of withdraws need to be large enough. Otherwise banks would find a different way to convert debt claims into currency. A lack of confidence in the American banking system is the main trigger leading to banking panics, which caused the Great Depression according to Friedman and Schwartz (1963).

There are two different theories explaining why debt holders want banks to substitute their debt claims into cash at a single blow, more precisely what the origins of banking panics are. For a better understanding a panic is defined as “an excessive or unreasoning feeling of alarm or fear leading to extravagant or foolish behaviour, such as that which may suddenly spread through a crowd of people” (New Shorter Oxford Dictionary, 2002). Compared to single banking failures or suspensions, a banking panic is mostly related to fear and a loss of depositor’s confidence in financial institutions (Wicker, 1996).

3.1.1 Random Withdrawal Theory

The first theory is called the “random withdrawal” theory and states that banking panics are events occurring because of random deposit withdrawals (Diamon & Dybvig, 1983). This theory implies that optimal bank contracts, namely deposits at par value, lead to costly banking panics. The purpose of so-called par value deposits is to offer an improved risk-sharing adjustment compared to the ones accessible in competitive markets. In this model banks are the main operator insuring depositors against risk since depositors are not sure about their future consumption and long-term investments are quite expensive to liquidate. Despite of the higher fixed rate in case of liquidating depositors usually opt for long-term investments since they entail higher returns. If depositors’ preferences of consumption change and deposits have to be liquidated, a first come first serve rule comes into effect. One talks about banking panics at the time when all depositors ask for redemption and a bank is not able to disburse all its liabilities at par. A fear of being the last depositor withdrawing its money will arise when depositors expect other depositors to withdraw their money. This reaction could lead to a banking panic due to random withdrawals.

3.1.2 Asymmetric Information Theory

Second, banking panics have originated from depositor’s rational behaviour liquidating their deposits whenever they are not allowed to have deeper insights into the loan portfolios of their banks. This theory is labelled the “asymmetric information” theory (Calomiris & Gorton, 1991). Banking panics emerge due to information asymmetry. It contains the assumption that depositors react when they do not receive the whole information about the value of banks’ asset portfolios and at the same time receives unfortunate news about the macro economy. Also the banks’ market structure plays an important role in the asymmetric information theory since the United States has a unit- banking system in which banks act like institutions. As soon as depositors assume that a bank is likely to fail they will continue withdrawing money from banks. Calomiris and Gorton (1991) say that bank runs are the perfect response of depositors. It is the best possible way for depositors to value banks’ assets. If depositors assume that there is a bank that may become insolvent, but cannot identify the under-performing bank, depositors could trigger a system wide banking panic to suspend unwanted banks. Consequently, banking panics can be seen as a kind of depositor’s monitoring of banks.

3.2 Banking Failures

According to the previous chapter high banking failure rates were the main output of the banking panics and consequently reflect the financial crisis of the Great Depression to some extent. It is of great importance to precisely investigate the banking failures during the banking distress of 1929 until 1933. In this paper banking distress is defined as banking failures in the interaction with deposit contractions.

Since there are different definitions for banking failures across the literature and the terms of banks’ suspensions and banking failures are often used interchangeable a short definition of both will be provided. Banking failures only include banks that are closed because of sudden liquidation, whereas bank suspensions concern all banks that closed due to financial difficulties as insolvency. In some cases suspended banks were reorganized and reopened to resume operations although they suspended before. In the following chapter current available literature referring to causes, determinants, severity and geographical distribution of banking failures will be summarized. Both, macroeconomic as well as microeconomic theories will be considered in order to explain how banking failures arose.

3.2.1 Causes And Subsequent Banking Failures

There are several historians providing theories of the financial crisis but with different approaches. Historians as for instance, Keynes (2000) and Temin (1976) only focused on factors like under consumption, unbalanced budgets, and bad institutional structures for several years. Afterwards, however, an increasing number of researchers did not only consider failures of fiscal policies, but started considering monetary policies as well. Friedman and Schwartz (1963) are outstanding advocates including both aspects, fiscal and monetary policies, when finding the main triggers for the banking crisis during the Great Depression. Other historians like Wicker (1980, 1996), Calomiris and Mason (2000, 2003), Temin (1989), White (1984), Richardson (2006,2007) and Bernanke (1994) investigated, similar to Friedman and Schwartz (1963), theories under both aspects. The following chapter will provide brief insights into theories merely based on the fiscal policy problem and will then continue with a comprehensive representation of theories, including monetary factors as well. For a better understanding reasons for banking failures are stated in the context with the whole financial crisis between 1929 and 1933.

Keynes (2000) came up with a theory for normal economies that states that there is a circular flow of money. In contrast to the classical model of macroeconomic his focus is on the analysis of aggregate demand.

According to him a decline in aggregate demand created a recessionary gap during the Great Depression. In other words, the decline took the economy below its potential output and caused a decrease in the gross domestic product. The drop in aggregate demand started with the collapse of the investment boom just before the Great Depression. Companies reduced its investments due to the fact that they had a high stock of capital after the investment boom. As explained above, the following Stock Market Crash in 1929 created uncertainties and caused additional investment cuts. Consequently a total decrease in real gross private domestic investments of almost 80 percentages during the Great Depression was caused. The Stock Market Crash only reduced the wealth of five percentages of Americans. However, in addition to investment cuts the Great Crash also caused a decline of general consumption due to the fact that consumer became more uncertain about consumption. Even fiscal policies triggered a decline of aggregate demand. Due to the fact that general consumption and income decreased, tax revenues fell. Therefore, the United States government tried to balance their budget by increasing taxes. This even decreased consumption and investments further. Keynes recommended a fiscal policy in order to overcome the financial crisis. Enormous government investments and pump priming would have been the solution according to him.

Amongst others, Temin (1976) raised the question what could have caused the Great Depression and subsequent banking failures. He took both possible aspects, monetary factors as well as the continuing decline in expenditures, into consideration. In his eyes an exogenous decrease in consumption rather than in investments was the main cause of the Great Depression. According to him monetary forces, the Great Depression being a consequence of banking failures or even errors of the Federal Reserve System’s policy, didn’t play an important role. For Temin (1976) banking failures were mainly triggered by worse agricultural conditions. He provides empirical evidence that banking failures and cotton sales, in other words, farm income, are highly dependent on each other. According to Temin’s (1976) study, it is proven that a decline in consumption caused banking failures.

Concluding, according to Keynes (2000) and Temin (1976) a decrease in real gross private domestic investments, a reduction in consumption and a resulting tax increase, caused by the lack of trust in the American banking system, were essential factors triggering the financial crisis during the United State’s Great Depression.

For several years, historians as Keynes (2000) and Temin (1976) only focused on factors like under consumption, unbalanced budgets, and bad institutional structures. Afterwards, however, an increasing number of researchers did not only consider failures of fiscal policies, but started considering the failures of monetary policies as well. Friedman and Schwartz (1963) are outstanding advocates including both aspects, fiscal and monetary policies, when finding the main triggers for the banking crisis during the Great Depression.

In order to gain sufficient answers and estimate the causes of the Great Depression, it is also of great importance to know if the banking failures were really panics according to illiquidity shock or are rather simply caused by insolvency during 1929 until 1933.

The starting point of Friedman and Schwartz’s hypothesis is the Wall Street boom in 1928. The Federal Reserve System tightened laws and policies since they were worried that the increase in asset prices would lead to an intense inflation.

Shortly after the start of the recession in the beginning of August 1929, the Wall Street Crash of 1929 happened. In contrast to several researchers, for Friedman and Schwartz (1963) the Wall Street Crash of 1929 was not seen as a cause of the following depression, but rather as an inducement since it encouraged the population to liquidate their deposits. According to Friedman and Schwartz (1963), the actual problem were four banking crises since they “worked through the money multiplier to reduce the money stock via a decrease in the public’s deposit to currency ratio” (Bordo & Lane, 2010, p. 3). The banking crisis induced banking failures due to the fact that banks suffered from illiquidity and therefore a decline in money supply arose.

Friedman and Schwartz differentiate between four nationwide banking crises. The first one lasted from the end of 1930 until March 1931. There was a general anxiety distributed across the country since the whole population raised fears being the last one who converts deposits into cash. Consequently, banking panics occurred and suddenly many depositors wanted to withdrawal currency for their debt claims.

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Pages
49
Year
2015
ISBN (eBook)
9783668170001
ISBN (Book)
9783668170018
File size
2 MB
Language
English
Catalog Number
v316740
Institution / College
EBS European Business School gGmbH
Grade
1,3
Tags
greatdepression; bankingfailures bankingdistress commercialbanks valueatrisk americanbankingsystem financialcrisis bankingpanics randomwithdrawaltheory asymmetricinformationtheory baselaccords valueatriskmeasurement

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Title: Banking Portfolios and Banking Distress During the Great Depression in the U.S.