What can we learn from 19th century US history about the causes of banking crisis?

This essay will argue that the lessons that can be learned from the National Banking era (1863-1913) about causes of banking crisis must be understood within the context of the boom and bust cycle. Therefore, this essay will match the random withdrawal and the information asymmetry view with the empirical evidence during that period, but also base those views within the boom and bust cycle. While not necessarily ignoring other banking panics of that period, this essay will use the Panic of 1907 as a case study and therefore provide an alternative view on how causes of banking crisis are being analyzed. In fact, the Panic of 1907 resulted in the failure of at least 25 banks and 17 trust companies.

First, I will focus on the many different factors that may lead to a banking crisis. Second, I will focus on the lack of mechanism that existed to counter a banking crisis, and analyze why it is important that liquidity is provided in times of contracting credit. Third, I will argue that what we can learn from the causes of banking crisis is that as much as we can analyze what factors are leading to a banking crisis, we also need to find ways to cushion the financial system from external shocks or insure banks in other ways to stop them from exacerbating a banking crisis and potentially turning it into a financial crisis.

The first lesson that we can draw from the National Banking era (1863-1913) about the causes of banking crisis is that a banking crisis does not simply arise out of one, but rather many factors and it is a convergence of factors that determine the cause of a banking crisis. Banking crises arise out of a complex financial system and therefore it is impossible to deduce one factor as the single variable in causing a banking crisis. Financial markets, by default, are complex structures and financial institutions are interconnected and intertwined in a network that interacts with each other on an international level. While financial markets may have become truly global only in the past twenty-five years, they have been arguably integrated on an international level since the onset of the Dutch and English East India Companies.

Even though information might not have traveled as fast as it does today, by the end of the 19th century financial markets had reached a level of interconnectedness in which different parts within the system were so interrelated that an event in South America could have had an impact on financial markets in Europe. One of the first banking crises, the Panic of 1825, in which speculative investments led to the closing of six London banks is an example of early integration of financial markets that has a negative effect on the banking sector. [1] Therefore, if we acknowledge that financial markets are highly complex and interconnected, we can realize that the causes of a banking crisis become only apparent in hindsight. This does not mean that the causes of a banking crisis cannot be determined in advance, but before the crisis there are only few people who recognize the causes of an impending crisis for valid reasons. The majority, due to the complexity of the system, has no clue what is going on and even many experts under or overweigh certain variables that lead to a banking crisis.

Therefore, we will only be able to derive the causes of a banking crisis if we acknowledge that there are many forces that go into the equation. The Panic of 1907 in many ways can be regarded as the culmination of the many banking crisis that preceded it. Besides, considering that the birth of the Federal Reserve was inspired by the Panic of 1907, we can draw many lessons from that one panic. First, banking crises are much more likely in an interconnected system. By the end of the 19th century, the financial system was already so interconnected that the failure of one institution, or bank may cause other institutions or banks to fail, which were perfectly healthy. The number of financial institutions in 1907 stood at 16,000 so in one way the system then was even more interconnected, as the number of financial institutions today is smaller. Many of those institutions were connected through the same lenders and borrowers. The degree to which other institutions were being affected in the Panic of 1907 when one institution had failed should not be underestimated. One example to illustrate this is the speculation of Otto Heinz in the copper market. Otto Heinz was trying to drive up the price of United Copper Company shares, but as a result of his inability to do so, his own brokerage company went bankrupt. [2] This triggered bankruptcies of other banks, and later the bankruptcy of Knickerbocker Trust Company.

This domino effect can be ascribed to what is known as the contagion model in which a seemingly unaffected bank all of a sudden has to deal with issues initially caused by another part in the system. Another factor that may be labeled as a cause is what economists call information asymmetry. Not every market participant has access to the same information, and so a bank run can happen quite randomly. While the precise variables, which can account for panic-causing changes in perceived risk are a matter of debate, information asymmetry creates the possibility of panic. [3] Calomiris and Gorton argue that there is there is a consensus insofar as a smaller number of larger, branched, more diversified banks would likely prevent panics. [4] Another factor that goes into causing a banking or financial crisis is the economic boom that precedes it. Every major financial panic has occurred after an episode of rapid economic growth. [5] At the turn of the 19th century, the U.S. was the “emerging market” and increasingly capital flowed into the United States, which helped promote high one-digit economic growth. This growth created enormous demand for external financing and meant that the U.S. financial system had a low level of capital relative to the recent rate of demand. [6] This created weaknesses within the financial system, which were only being exposed after the crisis but reinforced during the boom period.

The next factor that causes a banking crisis is the external shock that shifts the boom into a crisis. This also leads the weaknesses to be exposed to the public, which negatively reinforces the bust cycle. To illustrate an external shock, we can take the San Francisco earthquake, which is attributed as one of the main triggers of causing the Panic of 1907. The San Francisco earthquake had the consequence that the Bank of England raised interest rates, and this led to an outflow of capital in the United States.

Another cause of a banking and financial crisis is the regulation that is being reduced, and the risk that is being increased during an economic boom. During the economic boom, demand for capital increases and institutions are taking more risks. Banks are lending money to people that they should not lend to in the first place, and governments create policies, which may support the bubble. When the external shock occurs, banks directors awaken to the inadequacy of their capitalization relative to the credit risks they have taken and banks reduce or cut off the new loans available to their clients. [7] A liquidity crisis ensues and financial markets change their mood, which spirals into a self-reinforcing negative feedback loop. The length and gravity of the crisis depends on how decisively action is taken by leaders to stop the spiral.

In the Panic of 1907, J.P. Morgan and a consortium of bankers and financiers stepped in to provide liquidity to the system. Therefore any lesson that we can learn from 19th century U.S. banking crises need to take into consideration that the nature of banking crisis causes is multi-fold. Only then can we learn lessons to help us mitigate future banking or financial crises.

The second lesson that can be drawn from the National Banking era (1863-1913) about the causes of banking crisis is the lack of mechanism that existed to provide liquidity during times of a contracting in credit. As every boom feeds from credit expansion, every crisis suffers from a contraction in credit. An essential feature of the banking industry then was the endogenous development of the clearinghouse, a governing association of banks to which individual banks voluntarily abrogated certain rights and powers normally held by firms. [8]

During the Panic of 1907, J.P. Morgan and a handful of financiers took action to provide liquidity to the financial system during the crisis as it spread to other institutions. Since banks are less willing to lend to other banks in times of credit contraction, the lesson is clear that we need to have a sort of lender of last resort. Friedman and Schwartz in their A Monetary History of the United States have been extensively arguing this by saying that the detailed story of every banking crisis in our history shows how much depends on the presence of one or more outstanding individuals willing to assume responsibility and leadership. [9]

During a banking crisis, there is a great amount of uncertainty and that uncertainty can only be elevated by a handful of leaders who have the willpower to act as a lender of last resort. This becomes clear when we draw an example from the Panic of 1907. A year before the Panic of 1907, Treasury Secretary Cortelyou and his predecessor Shaw increased government reserves of gold to strengthen the dollar. This took liquidity out of the financial system at a time when economic growth and the San Francisco earthquake and fire created an urgent demand for more cash. [10] Economist Glenn Donaldson has noted that market liquidity, or the lack thereof, is a primary element in determining the length and severity of a panic. [11]

Similar to a human being who runs out of oxygen, a financial system will collapse if it does not have liquidity to work with. In the decades leading up to the birth of the Federal Reserve, the existence of clearinghouses suggests that private agents can creatively respond to market failure. [12] However the clearinghouses were not adequate in handling the onset of a banking crisis.

Calomiris and Gorton compare the random withdrawal risk view to the asymmetric view as explanations for causes of US 19th century banking crises. According to the random withdrawal risk view, under the historical conditions of the United States, with unit banking and before federal deposit insurance, the basic problem is that there are not enough reserves to go around in time of crisis.[13] One solution would be to inject cash through open market operations to counter the panic.

However, during the National Banking Era the government was unable to conduct open market operations to inject cash. The U.S. Treasury was unable to purchase securities in sufficient amounts to prevent panics or effectively aid in their resolution. In fact, banks were unable to form an effective coalition to mitigate the effects of panic and banks as a group were unable to diversify withdrawal risk because reserves were unobservable. [14] Taken literally, this view suggests intervention in the form of open market operations or reserve requirements, which may make feasible private bank coalitions for diversifying withdrawal risk. However, to avoid moral hazard, liquidity should not be given out freely without any requirements. A distinction needs to be made insofar as the authorities need to distinguish between illiquidity and insolvency.

The problem then becomes that the difference between illiquidity and insolvency is very elusive. In principal, an insolvent bank should be allowed to go bankrupt. The only exception for an insolvent bank to receive short-term funding would occur if the bank threatened to affect other banks. Put simply, in a capitalistic system, the bad banks go bankrupt, so that the good banks can take over the assets of the bad bank and start over again. By propping up banks that are insolvent however, the good bank will have to compete with the bad bank that is on government support. This is not how capitalism is supposed to work. In a capitalistic system, the competent people take over the assets from the incompetent people, and then start over again.

One cause of a banking crisis is the excessive debt that a bank is taking on its balance sheet during the boom period, and if a bank is aware that it will be propped up when it is running into problems, then it is more likely to take on excessive risks. Nonetheless, if there is a run on a bank, and the bank is illiquid, meaning it can stay in business if it can meet short-term obligations, then there should be no reason not to help that bank. This would also help prevent a domino effect by which the failure of one bank will cause another bank run. We can acknowledge that providing liquidity during times of contracting credit is crucial, yet remain aware of the distinction that needs to be drawn in order to make the system working. On the other hand, according to the asymmetric information view, open market operations by themselves will not be considered effective in forestalling a panic because depositors do not want cash for its own sake but because the bank is failing. [15]

According to the information asymmetry view then, discount loans can be used as an effective way to transform illiquid bank assets into cash. Private clearinghouses historically provided the discount window through the insurance of clearing-house loan certificates. In regards to government lending to banks and deposit insurance, in both cases the government is willing to bear risks that are peculiar to the banking system. [16] With the creation of the Federal Reserve, which was modeled after the Bank of England, it seemed that a proper mechanism to counter contracting credit was found.

The third lesson that can be drawn from the National Banking era (1863-1913) about the causes of banking crisis is the lack of safety net or mechanism to distribute risk that existed to counter external shocks that would prevent a banking crisis in the first place. Drawing an example from the Panic of 1907, we noted instability among trust companies generally, and specifically in the cases of the Knickerbocker and the Trust Company of America. Brokerage firms, too, featured prominently: the failure of Otto Heinze & Co. and the near failure of Moore and Schley marked major turning points in the episode. [17] Tallman and Moen also find that in the Panic of 1907, unequal regulation among financial organizations led to a concentration of riskier assets in less regulated intermediaries, primarily trusts. They therefore suggest that allowing various types of institutions comparable access to all assets and investment opportunities might reduce the risk that the collapse of one type of asset would threaten the solvency of an entire class of financial intermediary. A cause of U.S. banking crises could then be that economic growth was achieved at the expense of economic stability, and a lesson is that we need to find a compromise between economic stability and growth and not achieve one at the expense of the other.

This essay has not solely focused on the empirical evidence of banking crisis, but instead used an alternative approach by using the Panic of 1907 as a case study to highlight the importance in understanding that a banking crisis does not arise out of one, but many factors which together may lead to a banking crisis.

One important lesson from the National Banking era about the causes of a banking crisis was the lack of a lender of last resort. Although it partly existed with the clearinghouses, there was overall no systematic way to deal with a banking crisis, or any crisis for that matter. To understand causes of a banking crisis in the future, we must understand its causes in the context of the boom and bust cycle.

One hundred years later after the Panic of 1907, we have still not fully understood the causes of a banking crisis, and financial markets are still following a pattern of boom and bust. So any lesson about the causes of a banking crisis need to be understood within the context of the boom and bust cycle.

Bibliography

Bruner, Robert & Carr, Sean. (2009) The Panic of 1907 (New York: Wiley, 2009)

Bordo, M (1998) Review May/June 1988 (St. Louis: St. Louis Review, 1998)

Calomiris, Charles & Gorton, Gary (1991) ‘The Origins of Banking Panics: Models, Facts and

Bank Regulation”, in R. Glenn Hubbard’ in R. Glenn Hubbard’s Financial Markets and Financial Crises (Chicago: University of Chicago Press, 1991)

Gorton, Gary (1985) ‘Clearinghouses and the Origins of Central Banking in the United States’,

The Journal of Economic History, 1985

Tornell, Aaron & Westermann, Frank. (2005) Boom-Bust Cycles and Financial Liberalization.

(Cambridge: The MIT Press, 2005)

Friedman, Milton & Schwartman, Anna. (1971) A Monetary History of the United States.

(Princeton: Princeton UP, 1971)

Moen, Jon & Tallman, Ellis. (1990) ‘Lessons from the Panic of 1907’, in Federal Reserve Bank

of Atlanta Economic Review, 75 (May/June 1990)

Footnotes

[1] Bordo, M., St. Louis Federal Reserve Review May/June 1998, 1

[2] Bruner, R. & Carr, S, The Panic of 1907, 43-44

[3] Gorton, G. Clearinghouses and the Origins of Central Banking in the United States, 279

[4] Calomiris, C. & Gorton, G. The Origins of Banking Panics: Models, Facts and

Bank Regulation, 164

[5] Tornell, A. & Westermann, F., Boom-Bust Cycles and Financial Liberalization, 1

[6] Bruner, R. & Carr, S, The Panic of 1907, 147

[7] Bruner, R. & Carr, S, The Panic of 1907, 166

[8] Gorton, G. Clearinghouses and the Origins of Central Banking in the United States, 277

[9] Friedman, M. & Schwartz, A. A Monetary History of the United States, 549

[10] Bruner, R. & Carr, S, The Panic of 1907, 165

[11] Bruner, R. & Carr, S, The Panic of 1907, 170

[12] Gorton, G. Clearinghouses and the Origins of Central Banking in the United States, 238

[13] Calomiris, C. & Gorton, G. The Origins of Banking Panics: Models, Facts and

Bank Regulation, 165

[14] Calomiris, C. & Gorton, G. The Origins of Banking Panics: Models, Facts and

Bank Regulation, 165

[15] Calamiris, C. & Gorton, G. The Origins of Banking Panics: Models, Facts and

Bank Regulation, 165

[16] Calamiris, C. & Gorton, G. The Origins of Banking Panics: Models, Facts and

Bank Regulation, 165

[17] Moen, J. & Tallman, E., Lessons from the Panic of 1907, 5