Banking Crises

In a chapter of the recently published Oxford Handbook of Financial History (available here) I define banking crises, consider the type of costs that they impose, and outline the most common causes of banking crises during the past 200 years.

Banking crises have been a common feature of the economic landscape for more than two centuries.  Although their frequency, severity, and geographic distribution have varied widely since the eighteenth century, with the exception of the period between the end of World War II and the early 1970s, they have never been completely banished from the world stage.  Banking crises are a particular form of financial crisis that results when a large proportion of banks fail, an especially large or important bank fails, or such failures are prevented only by extraordinary and direct intervention by the government, through the declaration of a bank holiday, or a reorganization or nationalization of the banking sector. 

The costs of banking crises are borne by four distinct entities.  Shareholders lose because the value of their equity declines.  In the case of limited liability, equity can fall to zero; when banks operate under an unlimited liability regime or where shares carry contingent liability, shareholders can be forced to contribute additional equity.  Holders of demand liabilities—demand deposits and, historically, banknotes—are also among the first to suffer when banks fail. Governments, quasi-government agencies, and the taxpayers who support them frequently bear some of the costs of banking crises by assisting failing or failed banks.  Finally, banking crises disrupt securities and currency markets and have macroeconomic costs. Doubts about the solvency of a country’s banking system can lead investors to pull their money out of the country. Such “capital flight” can lead to substantial volatility in exchange markets. Similarly, widespread fears about the stability of the banking system can lead to a disruption in securities markets, both because of the decline in bank share prices and because of distress selling by banks of their securities portfolios.

Crises can have substantial effects on the structure of banking systems as well. These include a decrease in the number and aggregate assets of financial institutions, along with a corresponding increase in banking concentration, with attendant effects on competition. Crises can also lead to a greater role for the government in the management of affected institutions. Finally, crises often lead policy makers to change banking regulations.  Reforms aimed at making the banking system more resistant to crises are politically popular in the weeks and months following crises; however, they also present an opportunity for interest groups take advantage of the sentiment in favor of reform to advance their own agendas.

Banks’ vulnerability to insolvency and, hence, crises, arises from the fact that their liabilities, primarily deposits, can be withdrawn at any moment, while the majority of their assets (i.e., loans and investments) often cannot be quickly, easily, and cheaply turned into cash.  Banks’ asset choices are governed by two conflicting motives: fear and greed.  Fear encourages banks to hold a smaller portion of their assets in loans and investments, which yield a return, and a greater share of their assets in cash, which is liquid and hence a good defense against large deposit withdrawals, but pays no return.  By contrast, greed encourages banks to load up on high yielding loans and investments and skimp on cash.

For the past two centuries, the vast majority of banking crises have resulted from boom-bust macroeconomic cycles. During the expansion phase (i.e., the boom), the number and assets of banks rise as bankers increase lending to take advantage of the expanding economy. In short, greed outpaces fear.  When the economic expansion ends and the bust phase of the cycle begins, marginal firms—those that were the last to receive funding—are unable to meet their debt service obligations.  The resulting loan defaults, declines in security values, and fall in the price level further exacerbates the distress. The debt-deflation spiral feeds on itself: loan defaults lead to the failures of banks and other intermediaries, exacerbating the macroeconomic downturn already underway.

The massive financial melt-down during the Great Depression (combined with the subsequent financial exigencies of World War II) led to what can only be called a “financial lock-down” as banks and the rest of the financial system were placed under severe regulatory constraints in order to prevent a recurrence of the financial catastrophe of the 1930s.  These constraints were successful, leading to the longest period of banking stability the modern world has ever known.  This stability came at a price, however.  Many of the constraints imposed on banks reduced the scope for—and the need to—compete for business.  Implicit or explicit government guarantees, such as deposit insurance in the United States, eliminated the need for bank customers to monitor and, if necessary, discipline poorly performing banks.  This reduced innovation in banking and led to the long process of deregulation, which led to greater financial instability and, in 2008, culminated in the subprime meltdown.

The factors that drove the subprime crisis are similar to those behind the frequent banking crises of the 19th and early 20^th centuries.  Stringent regulation has proven that it can prevent crises. However, it is clear that such regulation can be costly.

Richard S. Grossman is a Professor of Economics at Wesleyan University in Connecticut, USA, a visiting scholar at Harvard University’s Institute for Quantitative Social Science, and a Research Fellow at the London-based Centre for Economic Policy Research. This post is taken from his chapter “Banking Crises” in the recently-published Oxford Handbook of Financial History, co-edited with Youssef Cassis and Catherine Schenk.