grossman explaining bank stability during the depression

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The Shoe That Didn't Drop: ExplainingBanking Stability During the Great

DepressionRICHARD S. GROSSMAN

This article attempts to account for the exceptional stability exhibited by the

banking systems of Britain, Canada, and ten other countries during the Great

Depression. It considers three possible explanations of stability-the structure of

the commercial banking system, macroeconomic policy and performance, and

lender of last resort behavior-employing data from 25 countries across Europe

and North America. The results suggest that macroeconomic policy-especiallyexchange-rate policy-and banking structure, but not lenders of last resort, were

systemnatically responsible for banking stability.

Financial nstability plays an importantrole in many explanations ofthe causes andseverity of the GreatDepression.1The bankingcrisis

of 1930, for example, is widely regardedas having playeda crucial rolein turning he recession that beganin 1929 into the worst depressionin

U.S. history. Financial nstabilityduring he GreatDepressionwas notlimitedto the United States: throughoutEuropeindustrialdevastationwent hand in hand with financial collapse. Yet in Britain, Canada,Czechoslovakia, Denmark, Lithuania, the Netherlands, and Sweden,banking systems escaped the Depression without sufferingthe sort ofcrisis thatengulfedmuchof Europeand the United States.2Accountingfor the stabilityof these and other countriesis the goal of this paper.

Previous work on banking crises-particularly on those associated

with the Great Depression-has focused on the macroeconomicconse-quences of banking instability. The literature falls into two broadcategories. A monetarist view, identified with Milton Friedman and

The Journal of Economic History, Vol. 54, No. 3 (Sept. 1994). C The Economic History

Association. All rights reserved. ISSN 0022-0507.

Richard S. Grossman is Assistant Professor of Economics, Wesleyan University, Middletown,

CT 06459-6067.

A longer working-paper version of this article is available from the author. I have benefited from

comments by and discussions with Lee Adkins, Ben Bernanke, Michael Bordo, Bill Dewald, Barry

Eichengreen, Ben Friedman, Ken Kuttner, Stan Lebergott, Peter Lindert, Mike Lovell, David

Selover, Jeff Williamson, two anonymous referees, and seminar participants at Hebrew University,

Wesleyan, Yale, the Western Economic Association Meetings, and the National Bureau of

Economic Research Summer Institute. The research has been supported by the Alfred P. Sloan

Foundation, the Pew Foundation, and the German Marshall Fund of the United States. Aaron

Siskind provided valuable research assistance.' Friedman and Schwartz, Monetary History; Temin, Did Monetary Forces?; Bernanke,

"Nonmonetary Effects"; and Bernanke and James, "Gold Standard."2 Approximately one-third of U.S. banks failed between 1930 and 1933. The experience in

Europe, notably central and eastern Europe, was similar. Beyen, Money in a Maelstrom; James,

German Slump; Kindleberger, World in Depression; Lewis, Economic Survey.

654



Banking Stability During the Depression 655

AnnaSchwartzand PhillipCagan,holds that bankingcrises increase thepublic's desiredcurrency-to-deposit atio, thereby reducingthe moneysupply and leadingto a declinein outputor prices.3An alternativeview,articulatedby O.M.W. Sprague,IrvingFisher, HymanMinsky, CharlesKindleberger,and Ben Bernanke,is that bank failures raise the cost ofcredit intermediation,which depresses aggregateeconomic activity.4

Bankingstabilityduring he GreatDepression is of interestfor severalreasons. First, to the extent that bankingcrises contributed o the lengthand severity of the Depression, the relativestabilityof variousnationalbankingsystems may help to account for the differing evels of intensity

of the economic contraction. Second, understandingthe causes ofbankingstabilityduring he turbulentyears of the GreatDepression mayshed some light on the causes of Depression-era nstabilityelsewhere.Finally, the experience of countriesthat emerged from the Depressionwith their banking systems intact may suggest reformsthat will lessenpresent-day threats to financial stability.

Research on the causes of banking nstabilityhas been less common,and farless systematic, than that on its consequences. Investigationsof

the causes of crises typically focus on monocausal explanations ofbanking nstability. These explanationsmost frequentlyfall into one ofthree categories: the structure of the commercial banking system,macroeconomicpolicy and performance,and the actions of a lenderoflast resort (LOLR).

A number of authors have argued that instability results from thestructure of the commercialbanking system, particularly rom restric-tions on banks' powers. Charles Calomirisand Gary Gorton, DavidMengle, and ElizabethLaderman,RonaldSchmidt,and GaryZimmer-man, for example, maintain that banking systems characterized by ahigh degree of concentration and extensive branch networks enjoygreater diversification-and thereforegreater stability-than unit bank-ing systems.5 Others, includinga former U.S. Secretary of the Trea-sury, have arguedthat Americanbankingstability s threatenedby lawsandregulations hatpreventbanksfromexpanding ntorelatedfinancialservice industries, such as securities underwriting, brokerage, andinsurance.6

A second group of explanations focuses on poor macroeconomicpolicy and performance. Though there is evidence to suggest thatfinancial instability leads to a decline in aggregateeconomic output, it

3 Friedman and Schwartz, Monetary History; Cagan, Determinants and Effects.

4 Sprague, History of Crises; Fisher, "Debt-Deflation Theory"; Minsky, Inflation, Recession;

Kindleberger, Manias, Panics, and Crashes; Bernanke, "Nonmonetary Effects."

5 Calomiris and Gorton, "Origins of Banking Panics"; Mengle, "Case for Interstate Branch

Banking"; Laderman, et al., "Location, Branching."

6 See U.S. Treasury, Modernizing the Financial System, submitted by former Treasury

Secretary Nicholas Brady. See White, "Before Glass-Steagall," on the investment bankingactivities of national banks.



656 Grossman

can also be argued that bank failures themselves are a consequence ofeconomic downturns. According to the traditionalKeynesian view, the

Depression had its originsin a dropin investment spending, which wasdriven by a decline in investor confidence. Peter Teminmaintainsthatbank failures during the Depression were primarily the result of aneconomic contraction that originated in an inexplicable autonomousdecline in consumption expenditures.7BarryEichengreen and JeffreySachs and Temin note that countries that clung to the gold standardexperienced more severe economic downturnsin the 1930s than didcountries that devalued, arguing implicitly that bank failures resulted

from the choice of monetary regime and exchange-rate policy.8 Eichen-green and Richard Portes argue that capital flight engendered bymaintenanceof inappropriatepre-World War I parities linked convert-ibility crises and domestic banking nstability.9

A thirdgroupof explanationsasserts that centralbanks are the crucialelement in maintaining inancialstability.CharlesGoodhart,for exam-ple, argues that the regulatoryand supervisory services provided bycentral banks contribute o stability.10Moreimportantly,HenryThorn-

ton, WalterBagehot, and Kindlebergerhave arguedthat by providingliquidity to the market during financial stringency, central banks arecrucial to the maintenance of financialstability.1"Therefore, the ab-sence of a central bank or the unwillingness of a central bank toundertakethe role of LOLR may bear some responsibility or financialinstability.

To explain why some countries had stable banking systems whileothers experienced banking crises, I contrast the interwar banking

environments.Did countrieswithbankingstabilitydiffer rom countriesthat experienced crises in banking structure, or in macroeconomicpolicy andperformance,or in LOLRbehavior?If so, did the differencehelp to account for their exceptional experience? To answer thesequestions I assemble and analyzedata on bankingstructure,macroeco-nomic policy and performance,and LOLR behavior from 25 countriesacross Europe and North America. Though the data suggest thatmacroeconomic policy and performance-especially exchange-rate

policy-and bankingstructurehelpto explainbankingstability,I findnosystematicevidence thatLOLR behaviorcontributed o bankingstabil-ity.

7 Temin, Did Monetary Forces?8 Eichengreen and Sachs, "Exchange Rates"; Temin, Lessons.

9 Eichengreen and Portes, "Anatomy"; Eichengreen, Golden Fetters.10 Goodhart, Evolution of Central Banks." Thornton, Enquiry into the Nature; Bagehot, Lombard Street; Kindleberger, Manias, Panics,

and Crashes.



658 Grossman

Branching

One structural factor that may have contributed to banking stability isbranching. Extensively branched banks should be less likely to fail thanunit banks for three reasons. First, banks with an extensive branch

system are likely to have a more diversified loan portfolio than unitbanks, which make loans in one area only. Second, branched banks mayhave a more diversified deposit base and therefore may be less likely tofail due to purely local deposit runs. Finally, a branch system providesseasonal diversification, easing the stringency in money centers caused

bythe

flow offunds to agricultural areas at harvest time.16

Data on branching in crisis and noncrisis countries are presented inTable 1. Banks in noncrisis countries had, on average, substantiallymore branches per bank than their counterparts in crisis countries,

though the difference in means is not quite significant at the 5 percentlevel (one-tail test). Banks in Britain (613 branches per bank) andCanada (370) were by far the most extensively branched in the sample,although those in the noncrisis countries of Finland (36), Sweden (34),Czechoslovakia (27), and the Netherlands (24) also had more branches

per bank than the most extensively branched crisis-country banks ofBelgium (14) and France (9). These figures, plus those on less exten-

sively branched banks, may suggest that branching contributes to

stability only above some threshold (15 to 23 branches per bank).The Canadian experience in particular lends support to the argument

that branch banking contributes to stability. Macroeconomic perfor-mance during the Depression was dismal in both the United States and

Canada; however, the extensively branched Canadian banking system

survived intact while approximately 5,000 U.S. banks-primarily unitbanks-failed. Though the U.S.-Canada comparison is suggestive,numerous counterexamples cast doubt on the ability of branching to

ensure stability.The vast majority of American bank failures in the 1930s were unit

banks. Prominent exceptions included Caldwell and Company, which

had over 100 branches and affiliates in several southern states, and the

Bank of United States, which had 59 branches at the time of its failure. 17

Austria's largest and most extensively branched bank, the Credit

Anstalt, failed in May 1931. In Germany, the Danat Bank, which wasthird among Berlin's great banks with 207 branches, failed weeks later.In France, the country's fourth largest bank, the Banque Nationale de

Credit, failed following two runs. And Italy, where the banking system

16 Miron, "Financial Panics." Madden and Nadler, International Money Markets, p. 114, argue

that the branch systems of Europe were more adept at handling this seasonal movement of funds

than the correspondent system in the United States.

17 Wicker, "Reconsideration," discusses the collapse of the Caldwell group. Friedman and

Schwartz, Monetary History, pp. 309-11, and Temin, Did Monetary Forces?, pp. 90-94, discuss

the failure of the Bank of United States.



660 Grossman

extensively branched and did suffer crises, whereas the unit banksystem of Bulgariadid not experience crisis. This suggests that branch-

ing may have been but one factor contributing o banking stability.

Bank Concentration

Stability might also be explained by a high degree of bankingconcentration.If highconcentrationreflectsthe existence of barriers oentry, industrial organization theory suggests that firms may earneconomic profit and therefore may be less likely to fail. Further, theexistence of a smallnumberof banks suggeststhatcooperation,such as

pooling reserves in times of crisis, will be more feasible.Table 1 presents one measure of concentration-population per

bank.18According to this measure, banks in noncrisis countries hadconcentration evels that were, on average, more than five times thoseof crisis countries, and the difference is significantat the 2.5 percentlevel. British banks(nearly2.5 millionpeople per bank)were easily themost concentrated, whereas among crisis countries concentrationwashighest in Poland (487,900).Not surprisingly,concentrationwas quite

low in the unit-bank-dominatedUnited States (16,200).Did high bank concentration ead to greaterprofitability nd therefore

to greater stability? This question is addressed in Figure 1, whichpresents data on bank profitability.Curiously,banksin crisis countrieswere more profitablethan those in noncrisis countries throughouttheperiod 1929to 1933. Thoughthe highly concentratedbanks of Britainearnedbelow-average profits priorto 1931,theirprofits-like those ofnoncrisis-countrybanks in general-deteriorated less than those ofcrisis-countrybanks.

The data presented in Figure 1 indicate that (highly concentrated)noncrisis-countrybanks were not particularlyprofitablecomparedwiththeir crisis-country counterparts, although the decline in noncrisis-countrybankswas substantiallyess dramatic han thatof crisis-countrybanks. The profitability igures may indicatethat concentrationengen-dered conservative managementpolicies-a willingness to accept lowbut stable profits-or that more concentratedbanks were indeed moreprofitablebutdissipatedthese profitsthroughhigherreserve holdings.9

Noncrisis-countrybanksinfact heldgreatercash reserves than banksincrisis countries (though the difference is not statistically significant),which is supportive of the view that concentration contributed tobanking stability.

Concentrationmight also have bolstered bankingstability by facili-

18 The data required to calculate n-firm concentration ratios or Herfindahl-Hirschman indices are

available for only a few countries.9 Regressing cash ratios on profitability (and a time trend) using pooled time series-cross section

data yields a coefficient of 0.24, with a t-statistic of 3.17, suggesting that more profitable banks did

hold higher cash ratios.




0.35 -

0.3-

UnitedStates

0.25 -

5: 0.2-

0 CrisisCountries4 \0.15

NoncrisisCountries

0.1

Britain

0.05 - I l1929 1930 1931 1932 1933

FIGURE 1

RATIO OF PROFITS TO CAPITAL

Sources: League of Nations, Commercial Banks, 1925-33 and Commercial Banks, 1929-34.

tating interbank cooperation. Gorton describes how the New Yorkclearinghouse acted to pool the resources of its members duringnineteenth-century crises, and Charles Calomiris and Larry Schweikartdiscuss the importance of coordination as a response to the crisis of1857.20 American clearinghouse associations continued to functionsuccessfully into the interwar period. Similarly, bankers in Canada-informally and through the Canadian Bankers Association-exhibited a

high degree of cooperation, particularly during the takeovers of theBank of Ontario (1906) and Sovereign Bank (1908).21

Clearinghouses had existed for some time in Britain, but theyengendered far less interbank cooperation than bankers' organizations

in Canada or the United States. The London clearinghouse was estab-lished in the 1770s but did not admit joint stock banks until 1854 orprovincial private banks until 1858.22 The clearinghouse not performany function beyond check clearing, and interbank cooperation beforeWorld War I was minimal.23 Even during World War I, when wartime

20 Gorton, "Clearinghouses"; Calomiris and Schweikart, "Panic of 1857."21 Johnson, Canadian Banking System, pp. 104-27.22 Crick and Wadsworth, A Hundred Years of Joint Stock Banking, p. 29.23 Balogh, Studies in Financial Organization. An exception was the rescue of Baring Brothers in

1890.



662 Grossman

conditionsmade some cooperationnecessary, observersnoted thatthebankerswere not particularly nthusiasticparticipants.24

The evidence presented in this section suggests that high concentra-tion did contributeto bankingstability duringthe Great Depression.Banks in noncrisis countries earned lower-but comparativelymorestable-profits, while maintaining elativelyhighcash reserves. Thoughconcentrationdidfacilitateinterbank ooperation n Canadaandamongmembersof U.S. clearinghouses, t does not appear o have encouragedstability-promotingooperationamongthe highlyconcentratedbanksofBritain.

Bank Size

Bank size may also have contributedto banking stability. Largebanksmay be less proneto failurethan smallerinstitutionsfor severalreasons. First, banks with substantialassets will be better able todiversify their loan and investmentportfolios and thereby reduce therisk from any one nonperforming omponent. Second, if leading firmsrequirelargerloans-which small banks do not have the resources to

provide-and are less likely to defaultthan smallfirms, then the banksthatmakethese loansmay incur smaller oanlosses.25Third,banks withsubstantialresources may be in a betterposition to acquirebanksthatareon the verge of failureandthushelpto stabilize the system. Finally,highly capitalizedbanks will be better able to absorblosses from anynonperforming sset thanbanksthat areless highly capitalized.26Table2 presents data on averagebankcapital, assets, and deposits.

The averagejoint stock bank in noncrisiscountrieswas substantially

larger than that in crisis countries. The capital-to-assetsratio did notdiffersignificantlybetween crisis-countrybanks and noncrisis-countrybanks. Withoutmoredetaileddataon bankloanportfolios,it is difficultto determinewhetherrelativelylargebanks held more diversified oanand investmentportfolios than their smallercounterparts.Despite thisabsence of evidence, the stability of severalcountriescharacterizedbysmall banks (for example, Denmarkand Spain), and the instabilityofseveral countries characterizedby large banks (Belgiumand Switzer-land), the substantial size difference between crisis- and noncrisis-

country banks is suggestive.Banking systems characterizedby banks that commandsubstantial

resources mightenjoy greaterstabilitybecause such largebanks havethe resources to acquire ailing institutions. The cooperative effort torescue Baring Brothers in 1890 was such a case. In Canada. the

24 Balogh, Studies in Financial Organization; Committee on Finance and Industry, Report, pp.160-61.

25 Large banks may also enjoy economies of scale.26 If, however, large banks are typically stable, then they may be able to afford to hold less

capital.




TABLE2

BANK

SIZE,

1930

Capital-

Capital-

Average

to-

Average

to-

Crisis

Capital+

Average

Average

Assets

Noncrisis

Capital

+

Average

Average

Assets

Countries

Reserves

Assets

Deposits

Ratio

Countries

Reserves

Assets

Deposits

Ratio

Belgium

2.62

12.53

9.66

0.118

Britaina

43.92

686.09

601.26

0.035

Estonia

0.07

0.93

0.46

0.062

Bulgaria

0.07

0.40

0.31

0.146

Germany

1.30

13.09

8.27

0.099

Canada

27.87

285.23

225.67

0.046

Hungary

0.20

1.53

0.98

0.083

Czechoslovakia

4.42

43.03

26.76

0.058

Italy

0.62

5.25

1.45

0.118

Denmark

0.63

4.52

3.14

0.093

Latvia

0.33

1.78

0.61

0.165

Finland

2.54

15.63

11.41

0.106

Norway

0.65

4.09

2.57

0.117

Lithuania

0.30

1.47

0.93

0.192

Poland

0.60

5.35

2.10

0.087

Netherlands

26.69

137.69

98.70

0.128

Romania

0.09

0.45

0.29

0.128

Portugal

0.55

2.73

1.72

0.141

Switzerland

2.24

18.36

13.52

0.094

Spain

0.77

6.69

3.72

0.081

United

States

0.47

3.86

2.63

0.060

Sweden

7.46

50.98

32.44

0.090

Yugoslavia

0.10

0.50

0.39

0.163

Average

0.77

5.64

3.58

0.11

Average

10.47

112.22

91.46

0.10

Standard

0.81

5.61

4.21

0.03

Standard

14.44

199.38

173.75

0.05

deviation

deviation

Average

Capital-

Capital+

Average

Average

to-Assets

Reserves

Assets

Deposits

Ratio

Intergroup

differencein

means

9.70

106.58

87.88

-0.01

(t-statistic)

(2.22)

(1.77)

(1.68)

(-0.37)

p-valueb

1.9%

4.5%

5.3%

35.7%

a

England

and

Wales.

b

One-tail

test.

Note:

All

figures

except

capital-to-asset

ratios

are

in

millions

of

1930

U.S.

dollars.

Source:

League

of

Nations,

Commercial

Banks,

1925-33.




Germanbanks' outstanding loans to customers had been made withfunds borrowed abroad and subject to recall on demand. The Leagueestimated that the proportion was about one-quarterfor Austria andHungary.29

Figures on short-term foreign liabilities are not available for morethan a few countries, making it difficult to judge the extent of theexposure of banks in crisis and noncrisis countries. It is possible,however, to gauge the length of the periodof exchange rateuncertainty,because such uncertainty clearly ended when countries imposed ex-change controls or devalued their currencies.

Suggestively, none of the three countries that had either suspendedthe gold standard or imposed exchange controls prior to the CreditAnstalt crisis in July of 1931 suffered banking crises.30 Of the 14countriesthatsuspendedbetween the collapseof the CreditAnstalt andthe end of 1931, half underwentcrises and halfavoided crises.31Sevenof the nine countries that delayed suspension until 1932 or laterexperiencedbankingcrises.32

Given the paucity of data on foreign liabilities, it is impossible to

accept or reject the hypothesis that excessive dependence on foreigndeposits or prolonged exchange rate uncertainty were importantsources of banking instability. However, the data are suggestive.Banking systems in countries that suspended the gold standard orimposed exchange controls early-and hence reduced the incentive forcapital flight-appear to have been more stable duringthe Depressionthan those that clung to the gold standard.Thoughcontinued mainte-nance of the gold standard may well have increased the risk ofwithdrawalof foreign liabilities, it may have had a more profoundimpacton bank assets. It is to the asset side of the balance sheet that wenow turn.

Assets

Can bankingstability be explained by the relatively strong perfor-manceof asset portfolios? Poor asset performancecould weaken banksin three ways. First, because loans and investments constitute banks'principal earning assets, poor performancewill curb cash flow and

either reduce cash on hand, increasingthe risk of a run, or force thebank to hold a larger cash reserve, weakening its earnings position.Second, as some of these assets can be sold to satisfy demands bynervous creditors, if their value falls the marginof safety they provide

29 League of Nations, Commercial Banks, 1925-33, p. 10. See also James, "Financial Flows."30 Bulgaria, Portugal, and Spain.31 Austria, Estonia, Germany, Hungary, Latvia, Norway, and Yugoslavia had banking crises,

whereas Canada, Czechoslovakia, Denmark, Finland, Greece, Sweden, and the United Kingdom

did not.

32 Belgium, France, Italy, Poland, Romania, Switzerland, and the United States had bankingcrises, whereas Lithuania and the Netherlands did not.



666 Grossman

105 -

100 - a \,

\ \ ~~Noncrisis ountries ,

El95-\ /

o \ /~~~~~~~~~~~~~~~~

\Crisis Countries /90 -\/

/

/

\/~~~~~~~

85 L T

1929 1930 1931 1932 1933 1934 1935

FIGu PE 2

REAL GNP

Source: Mitchell, European Historical Statistics; Urquhart, Historical Statistics of Canada, p.

132; U.S. Department of Commerce, Historical Statistics of the United States, vol. I p. 224.

shrinks. Finally, given that loans anld nvestments typically constitute a

large fraction of total assets, the loss of part or all of their value could

seriously erode confidence. I consider loans and investments in turn.Were banks in noncrisis countries less adversely affected by poorly

performing loans than their counterparts in crisis countries? This wouldhave been the case if loans comprised a smaller portion of total assets innoncrisis countries than in crisis countries or if the loans made by banksin noncrisis countries outperformed those made by banks in crisiscountries. Banks in crisis and noncrisis countries held virtually the same

proportion of their assets in loans 46 vs. 47 percent in 1929 and 40 vs.41

percentin 1933. If the loan

portfoliowas a source of

strengthfor

banks in noncrisis countries, it was through better performance and not

substantially lower exposure.Bank loans may have performed better in certain countries because

macroeconomic conditions were better or because banks in thesecountries achieved a more advantageous distribution of loans.3 Mac-roeconomic performance is summarized by data on GNP presented in

Figure 2. The decline in economic activity was smzallerand more gradual

33 Perhaps due to an early devaluation or more substantial depreciation of the currency.

Eichengreen and Sachs, "Exchange Rates."




in noncrisiscountries, suggesting hat borrowers n these countriesmayhave been less likely to defaultthanborrowers n countriesmarkedbybanking crises. GNP in crisis countriesdeclined more sharply than innoncrisis countries even prior to the crisis year of 1931 (althoughthedifference is not significant),suggestingthat despite the difficultiesofinterpretation due to simultaneitymacroeconomic performance mayhave contributedto banking stability.

Tojudge how adverselybankswere affectedby the decliningvalue oftheir securities portfolios,it is necessary to considerthe extent to whichbanks in different countries held bonds, the performanceof the bond

marketin differentcountries, and the compositionof bond portfolios.The share of assets held in securities by noncrisis-countrybanks

exceeded that held by crisis-countrybanks(11.5 to 6.5 percentin 1929,14 to 9 percent in 1933), although the proportionof assets held insecurities was small comparedwith that held in loans. If bonds wereperceived as being less risky thanloans, this comparison suggests thatnoncrisis-country banks were more risk-averse than crisis-countrybanks.

Bond marketperformancecan be evaluatedby examiningthe yieldson long-term bonds, which are inversely related to bond prices, indifferentnationalmarkets. Data on bond yields are presentedin Figure3. Though yields in crisisand noncrisiscountrieswere similaruntil1931,during1932the crisis-countryrate rose dramatically, ndicatinga moreprecipitous decline in bond prices in crisis countries.This pattern mayreflect easier monetary policy undertakenby devaluingcountries. Thedata in Table 3 confirm that, on average, noncrisis countries saw

substantiallygreatercurrencydepreciationpriorto 1932than did crisiscountries.

To evaluate the effect of bond portfolioperformanceon the value ofbank assets it is necessary to address both bond marketperformanceand portfolio composition. Both concerns can be addressed by con-structing hypotheticalbank bond portfolios. These portfolios are gen-eratedby constructingseveral randomsamplesof bonds, each of whichis comprised of one type of security, and weightingeach component

according to the extent to which it was held in bank portfolios.34Because detailedportfoliocompositioninformation s availablefor onlya few countries, I restrict the analysisto one crisis country, the UnitedStates, and one noncrisis country, Britain. The initial samples werecollected frombondmarketquotesfor June30, 1929,andwerefollowedat six-monthintervalsuntil June 30, 1933.The results are reportedinFigure4.

3 Temin, Did Monetary Forces? pp. 106-8, conducts a similar exercise, although he constructs

just one sampleof bonds. The details of the procedure used here are omitted from the text but are

contained in a longer working-paper version of this article, which is available from the author.



668 Grossman

140 -

130 CrisisCountries

120

110A

100

90 NoncrisisCountries \

80 - l l l l

1929 1930 1931 1932 1933 1934FIGURE 3

BOND YIELDS

Source: League of Nations, Statistical Year-Book, 1934135.

Government issues performed well in both countries. In the United

States railroad, industrial, and foreign issues performed poorly, losing

between 38 and 53 percent of their value by June 1932, whereascomparable British securities lost only 36 percent of their value. The

performance of British and American portfolios was similar until

year-end 1931. Low interest rates, associated with postdevaluation easy

money policy, plus a more risk-averse bond selection helped the British

portfolio make a rapid recovery and to avoid losses at nearly all

semiannual dates.35 The British bond portfolio, which gained 19 percentin value over the entire period, contributed a 2.2 percent increase to the

value of total assets, whereas the American portfolio, which lost 11

percent of its value, accounted for a 2.5 percent fall in the value of total

assets.Both threads of analysis pursued in this section suggest that the

earning assets of noncrisis-country banks outperformed those of crisis-

country banks, and that early devaluation may well have been an

important contributing factor. The smaller and less dramatic downturn

in aggregate economic activity in noncrisis countries indicates that the

behavior of the loan portfolio was probably a less important source of

3S The British portfolio lost nearly 11 percent of its June 1929 value by year-end 1931.




TABLE 3EXTENT OF DEPRECIATION,DECEMBER 1931

Crisis Countries CurrencyValuea Noncrisis Countries CurrencyValuea

Switzerland 101.0 Lithuania 100.3Yugoslavia 101.0 Netherlands 100.1Franceb 100.3 Czechoslovakia 100.0Belgium 100.0 Greece 99.2United Statesb 100.0 Bulgaria 99.0Latvia 99.9 Canada 82.7Hungary 99.8 Portugal 73.0Poland 99.8 Sweden 69.8Estoniab 99.7 Denmark 69.4

Romania 99.6 Britain 69.3Germany 99.2 Finland 67.3Italy 97.1 Spain 57.2Norway 69.0

Average 97.4 Average 82.3Standarddeviation 8.3 Standarddeviation 15.7

IntergroupDifferencein Means 15.14(t-statistic) (2.98)p-valuec 0.36%

a Percentage of 1929value.b December 1930.c One-tail test.

Source: League of Nations, Monetary Review.

instability among banks in noncrisis countries. Bond prices held up

relatively well in noncrisis countries. Though the lack of detailed dataon bond portfolio composition limits an investigation of its importance,comparison of British and American bond portfolios suggests thatstrong bond marketperformance-due in partto postdevaluationmon-etary policy-combined with risk-averseportfoliomanagementcontrib-uted to the relative stability of Britain's banks after 1931.

LENDER OF LAST RESORT

Banking stability could also have been promoted by a lender of lastresort. An LOLR mighthelp to avoid or amelioratecrises by providingbanks with liquidityin times of stringency when, in the absence of suchassistance, they would be unable to meet the demands of depositors andwould be forced to close their doors. Such assistance would most likelybe made throughloans, which other marketparticipantsareunwillingorunable to make. Of course, LOLR performanceis not independent of

monetary policy. For example, Temin and Eichengreen argue thatmaintaining he gold standardmade it difficult or centralbanks to act as



670 Grossman

130

120 -

BritishComposite /

o110 /

clq

\/

-100

90 - / U.S.Composite

80 - I I I

June 29 June 30 June 31 June 32 June 33FIGURE 4

AMERICAN AND BRITISH BOND PORTFOLIO PERFORMANCE

Source: See text.

effective LOLRs.36 However, because LOLR behavior has figuredprominently-aside fromits effect on monetarypolicy-in the literatureon bankingcrises, I considerit separately.The firstpartof this section

considers the willingnessand abilityof various national authoritiestoperformthe lender of last resort function; the second evaluates theresponse of several nationalauthoritiesto crisis.

Centralbanksdifferedbothin the extent to whichthey competedwithdomestic commercial banks and in their relationshipto the moneymarket. Continentalcentralbankswere typicallygeneralbanks, whichwere entitled to conduct business with individualsand nonbankbusi-nesses as well as with banks. As profit-maximizingnstitutions, these

centralbankswere oftenin competitionwith domesticbanks,and hencemay not have been especially concerned with the stability of thedomestic bankingsystem. The Bank of France, for example, was inactive competitionwith French commercialbanks for deposits and bythe end of 1933 carried nearly 400,000accounts on its books.37

The Bank of Englandwas unrestrainedas to the institutions withwhich it was entitled to do business, but from early in the nineteenth

36 Temin, Lessons; Eichengreen, Golden Fetters.37 Truptil, British Banks, p. 83; Madden and Nadler, International Money Markets, pp. 112,

306-7.




centuryit beganto deal almostexclusivelywith other financial nstitu-tions. Following the demise of Overend, Gurneyin 1866, the Bank

ceased to be in active competitionwith other City firms. Thoughthe

Bank's relationshipwith the joint stock banks was limited to checkclearing,its relationshipwith the discount houses-and thereforethemoney market-was moreintimate.

Discount houses carriedportfoliosof acceptancesthat they financedwith call loans fromthe joint stock banks.Whenthe joint stock banksbecameilliquidandcalledin theirloans, the discounthouses turned othe Bank of England,whichstoodreadyto rediscountTreasuryor trade

billsfreelyat BankRate.Becauseof theirprivilegedaccess to the Bankof England, hediscounthouseswere subject o close supervisionby theBank.Thussupervised nstitutionsacted as a bufferbetweenthe LOLRand the unsupervisedoint stock banks.The joint stock banksdid notnormallyhaverecourseto the Bankof England,so theyhad a powerfulincentiveto avoid situations n whichcashand moneylentat callwouldnot be sufficientto meet depositor demand. The presence of thediscount marketallowedthem to maintainapproximately to 9 percent

of assets in liquid call loans in addition to their cash reserves ofapproximately10 percent.38

In New York, by contrast, though the central bank was not incompetitionwith memberbanks, its relationshipwiththe moneymarketwas more tenuous. The securities typicallypledgedas collateral forbroker'scall loanswerenoteligible or discountorpurchaseby the Fed.JohnMaddenandMarcusNadlerarguethatthe Londonmarket,whichhaddirectaccess to the Bankof England,wasat least theoreticallymore

liquidthanthe New Yorkmarket,where theliquidityof loans dependedon the marketability f the loan collateral.39

A second majordifferenceay in the abilityto engagein openmarketoperations.Theauthorityof the Bankof France,the NetherlandsBank,Reichsbank,and other continentalcentral banks to engage in openmarket operations-and hence to act as an effective lender of lastresort-was limitedby statute.40Openmarketoperationswere clearlywithin the prerogativeof both the Federal Reserve and the Bank of

England, though the Fed did not employ this techniqueeffectivelyduring he GreatDepression.The failureof FederalReservemonetarypolicyhasbeenfrequentlycited as a sourceof banking nstabilityn theUnited States.41

38 Balogh, Studies in Financial Organization, p. 36.

39 Madden and Nadler, International Money Markets, p. 118.

4 Madden and Nadler, International Money Markets, pp. 123, 310, 372-73. The Bank of France

was empowered to purchase gold and foreign exchange in 1926. The effects of these purchases were

similar to open market operations. See Eichengreen, "Bank of France.""' Friedman and Schwartz, Monetary History. Their argument does not focus on the Fed's

failure to act as LOLR, but on its failure to follow a stable monetary policy.



672 Grossman

150 -

140-

X \ Noncrisis Countries

130 -

/

8120 -/

ON10

100 /

I Crisis Countries

90

80 -1929 1930 1931 1932 1933

FIGURE 5

BILLS DISCOUNTED IN CENTRAL BANK PORTFOLIO

Sources: League of Nations, Monetary Review; Urquhart, Historical Statistics of Canada, p. 203.

It is difficult to construct a uniform measure of LOLR activitybecause the methods used by LOLRs varied widely.42 The presence ofa central bank with a reputation as a strong LOLR may even have

reduced the need for such an institution to have taken any action at all.One way of assessing the extent of expansionary open market

operations is to examine the level of discounting by central banks.43 As

shown in Figure 5, after declining slightly in 1930, discounting levels inboth crisis and noncrisis countries rose substantially in the crisis year of1931 before returning to 1929 levels by 1933. The expansion of billsdiscounted in noncrisis countries was substantially above that in crisiscountries (though the difference is not statistically significant), suggest-ing that central banks in noncrisis countries responded to the threatenedcrisis with more aggressive open market purchases.

The response to crisis varied widely. In Czechoslovakia, Scandina-via, and Spain, central banks expanded discounts in order to increaseliquidity and relieve pressure on the domestic money market. In

42 Measuring the extent of central bank discounting, as is done below, is problematic because

central banks had different accounting practices (and is complicated by Canada, which had no

central bank). Further, some governments extended lender of last resort facilities in difficult-to-

quantify ways-for example, by providing guaranteed depositories (Bulgaria, Lithuania).

4 Lovell, "Role of the Bank of England," assesses LOLR behavior in the eighteenth century byexamining the Bank of England's discounting activity.




Bulgariaand Lithuania,the provision of guaranteeddepositories alle-viated pressure on banking institutions and reduced the risk of panic.The remainderof this section brieflyoutlinesthe response of authoritiesin Britain and Canada, where LOLR actions were crucial in avertingcrisis.

With the collapse of the Credit-Anstalt in the summer of 1931,pressure immediatelyfell upon the London accepting houses that hadgranted substantial trade credits to their foreign clients." The subse-quent Austrian and German exchange controls made it impossible forfirmsin these countries to remit funds to London to dischargethe debt.Because all firmsthat had discounted or rediscounteda bill, as well asthe issuing firm, were "jointly and severally" liable, any number ofaccepting houses, discount houses, and joint stock banks might beforced to close if the issuer was unableto meet the debt.

The City had faced such a crisis when the outbreak of World WarIprevented foreign debtors from remitting unds to London. In 1914 theBritishgovernmentauthorizedthe Bankof Englandto discount frozenbills and to keep them in "cold storage" until after the hostilities,

guaranteeinghe Bankagainstany loss. Theresponse of the Cityin 1931was similar: he Bankof Englandcontinuedto discount frozenbills eventhough there was no government guarantee. This action relieved allissuers, discounters, and holders of bills from immediateliabilityandalmost certaincollapse.

Unlike the United States or the majority of European countries,Canadahadno centralbankbefore 1935.Currencywas issued in limitedamounts by both the chartered banks and the central government.

However, under the FinanceAct, the centralgovernmentwas empow-ered to act as LOLR: chartered banks could apply to a Cabinetcommittee for advancesof Dominionnotes againstvirtuallyany pledgedsecurity.45

Of even greater mportancewas PrimeMinisterBennett's decision torescue the "WheatPools." Every year the Pools accepted the crops ofits members, on whose behalf it sold the wheat, and advanced (bor-rowed) funds in anticipation of sales. In the absence of governmentsupport,the rapiddecline in wheatprices followingthe initialpurchaseof the 1929-1930crop could well have led to the collapse of both thePools and the banks that had extended them $22.8 millionin credit.46

Thus there is preliminaryevidence suggestingthat LOLR behaviorstabilized banking during the Great Depression. Central banks in

" As of March 31, foreign credits were ?121 million whereas foreign deposits were ?81 million.

Committee on Finance and Industry, Report.

4 McIvor, Canadian Monetary; Shearer and Clark, "Canada and the Interwar Gold Standard";

Drummond, "Why Canadian Banks Did Not Collapse."

4

This paragraph is based on Drummond, "Why Canadian Banks Did Not Collapse," pp.246-48.



674 Grossman

noncrisis countries expanded discounts more than did those in crisiscountries, and decisive LOLR activity by authorities in Britain andCanadaconfrontedthreatsthat, if not addressed,could well have led tobankingpanics.

ECONOMETRIC TESTS

The evidence presented earlier suggests that banking structure,macroeconomic policy and performance, and LOLR behavior eachcontributed o bankingstabilityduring he GreatDepression. However,

this evidence does not enable us to assess their relative importancesystematically. Though the nature of the three explanations makesdirect comparisons problematic, formal tests can provide tentativeanswers.47

Table 4 presents single-variableprobits for structural, macro, andLOLR variables. Among the structuralvariables, branchesper bank,populationper bank,andassets perbank all have the expected negativesigns, indicating that countries characterized by more extensively

branched,moreconcentrated,andlargerbanks were less likely to havea banking crisis. Only the first two of these are significantat the 5percent level (one-tail test). The estimated coefficient on the capital-to-assets ratio has a positive sign, though it is not significantlydifferentfrom zero.

To minimizethe simultaneityproblem,the tests on macroand LOLRvariables employ data from 1931.48Among the macro variables, theestimated coefficient on currencyvalue is positive andsignificantat the

2.5 percent level (with a p-value of 1.1 percent), indicatingthat thegreater the extent of currencydepreciation,the less the likelihood of abanking crisis. Probits on other macroeconomic variables yield esti-mated coefficients with the anticipated signs but not significantlydifferent rom zero. These results highlight he importanceof exchange-ratepolicy over macroeconomicconditions as a determinantof bankingstability.

The estimated coefficient on the LOLR variable has the expectednegative sign, indicatingthat an increase in central bank discounting

lowers the probabilityof a bankingcrisis butis not significantlydifferentfrom zero. This result is striking and suggests that despite anecdotalevidence and great stress placed on its importancein the literature,LOLR behavior does not provide a systematic explanation of bankingstability.

47 What would be the standardof comparison?A 5 percent increase in branchesper bankcomparedwith a 5 percent ncrease n centralbankdiscountingor a 5 percentdepreciationn thevalue of the nationalcurrency?

48 For countries that experienced banking crises in 1930(Estonia, France, and the UnitedStates), 1930data are used. Thisameliorates,but does not eliminate,the simultaneityproblem.




TABLE 4SINGLE-VARIABLE PROBIT RESULTS

(Dependent variable: countries that underwent a banking crisis = 1)

Log

Independent Variable Coefficient Constant N Likelihood

Structural variables Branches per bank -0.0920* 0.849** 25 -12.12

(0.0482) (0.401)

Population per bank -0.00329* 0.710* 25 -13.39

(0.00182) (0.388)

Assets per bank -0.0408 0.623 23 -12.05

(0.0283) (0.370)

Capital-to-assets ratio 2.507 -0.209 23 -15.85

(6.662) (0.748)Macro variablesa Currency value 0.0540** -4.874** 25 -13.55

(0.0219) (2.044)Freight-ton-kilometers -0.00381 0.174 22 -14.87

(0.0234) (0.437)

Industrial production -0.0152 -0.0824 20 -13.58

(0.0252) (0.445)

Real GNP -0.0271 -0.357 17 -11.39

(0.0546) (0.413)

WPIb -0.00998 -0.157 25 -17.26

(0.0321) (0.712)

LOLR variablea ACentral bank discounts -0.00672 0.171 25 -16.30(0.00509) (0.269)

* = One-tail test significant at the 5 percent level.

** One-tail test significant at the 2.5 percent level.a Variables represent 1931 values relative to 1929, except for Estonia, France, and the United

States, where 1930 values (relative to 1929) are used.b CPI for Lithuania.

Note: Figures in parentheses are standard errors.

Sources: For structural data, see Tables 1 and 2. For currency value, see Table 3. For other macro

variables, see League of Nations, Statistical Year-Book, and Mitchell, European Historical

Statistics. For LOLR data, see League of Nations, Commercial and Central Banks, and Urquhart,Historical Statistics of Canada, p. 203.

Ideally, the sources of banking stability should be evaluated withmultivariate ests, which wouldbe informativeon two levels. First, theywouldallow a systematic assessment of the relativeimportanceof eachof the three majorcategories. Second, they would enable us to assessthe relative importanceof the differentmeasures withineach category.However, because of the small number of observations and highcorrelationsamongthe variableswithin the majorcategories, such testsyield estimated coefficients with relatively large standarderrors. Onesuch multivariableprobitis presentedin Table5, specificationI, whichincludes two bank structure and two macro variables.Though four ofthe five estimated coefficients have the expected signs, only that oncurrencyvalue is significantat standard evels.49

4 Several resampling techniques, such as the bootstrap and the jackknife, have been developed

to improve small-sample inference. Efron, The Jackknife. Adkins, "Small Sample Inference,"



676 Grossman

TABLE 5MULTIVARIABLE PROBIT RESULTS

(Dependent variable: countries that underwent a banking crisis = 1)

Independent Variable I II III IV V VI VII

Constant -5.760 -4.166 0.612 0.335 -4.616* 0.377 0.440

(3.354) (2.578) (0.858) (0.516) (2.352) (0.912) (0.511)

Branches per -0.133 -0.121* -0.0858 -0.102*

bank (0.125) (0.0680) (0.0507) (0.0556)

Population per -0.00228 -0.00381 -0.00298 -0.00351*

bank (0.00304) (0.00230) (0.00184) (0.00186)

Currency valuea 0.0695* 0.0559* 0.0597**

(0.0382) (0.0286) (0.0259)

WPIa,b -0.0126 -0.0189(0.0368) (0.0381)

Freight-ton-kilo- -0.0664 -0.0563 -0.0320

metersa,C (0.0446) (0.0346) (0.0297)

ACentral bank 0.00355 0.00120 -0.00458 -0.00622 -0.000493 -0.00589 -0.00771

discountsa (0.0106) (0.00751) (0.00672) (0.00709) (0.00673) (0.00636) (0.00675)

N 25 25 25 25 25 25 25

Log-likelihood -7.402 -9.556 -11.743 -10.141 -9.515 -12.690 -12.173

* = One-tail test significant at the 5 percent level.

** = One-tail test significant at the 2.5% level.

a Variables represent 1931 values relative to 1929, except for Estonia, France, and the UnitedStates, where 1930 values (relative to 1929) are used.b CPI for Lithuania.c Freight-tons for the Netherlands, Portugal, and Spain.

Note: Figures in parentheses are standard errors.

Sources: See Table 4.

An alternativeapproach s to estimatemultivariableprobitsusingonemeasure from each of the three categories. This both economizes ondegrees of freedomand eliminatesthe multicollinearityproblem.50Theresults are reported in Table 5, specifications II through VII. Thecurrencyvalue yields consistently significantcoefficientsand is robustto changes in the bankstructurevariable.The estimated coefficientsonother macro variables have the appropriatenegative signs but are notsignificantat standard evels.51The estimated coefficientson both bankstructurevariables are negativeand significantat the 5 percentlevel inspecificationsII, IV, andVII (andat the 6 percentlevel elsewhere).Theestimated coefficienton the LOLRvariable s usually negative,although

it is nowhere significantat standard evels.The coefficients on currency value are consistently significant,but

other macroeconomicvariablesdo not performas well and are not asrobust to changes in bank structureand LOLR variables. This resultdemonstratesthe importanceof devaluationin allowing more accom-

concludes that bootstrapping a probit is not superior to the standard maximum likelihood

estimation.

s0 However, this procedure may introduce omitted variable bias.

s' In specification IV, the estimated coefficient on freight-ton-kilometers is significant at the 6percent level.




(1930). Run on banks following British departure from gold (1931).Temporary moratoria on banks by government (1931 and 1932).Government intervention through National Mortgage Bank and

other state banks.France Failure of local banks such as Banque Adam, Oustric Group,

Banque Renauld, Charpenay, Veuve Guerin; a regional bank,Banque d'Alsace-Lorraine; and the national Banque Nationale deCr6dit (1930-1931). Forced merger of major investment bank,Banque de l'Union Parisienne (1932).

Germany Failure of Berlin grossbank, the Darmstader und Nationalbank(Danatbank) and bank holiday (1931).

Hungary Run on Budapest banks, bank holiday (1931).

Italy Breakup of Banca Agricola Italiana. Panic and government reorga-nization of banks (1931).Latvia Run on banks following collapse of Danat and Credit Anstalt.

Government decree limiting depositors' right to make withdrawals.Norway Suspension of two of the country's largest banks, Bergens Privat-

bank and Den Norske Creditbank(1931). Temporary (three-month)moratorium on old deposits and government guarantee of newdeposits. Nordvik, in "Scandanavian Banking," argues that Nor-wegian banks were stable.

Poland Bank runs following Austrian and German banking crises. Severe

external and internal drains.Romania Run on or collapse of Banca Generala a Tarii Romanesti, Banca de

Credit Roman, Banca Romaneasca, Banca Marmerosch, Blank &Co., Banque Generale du Pays Roumain. Many banks placed underspecial protection pending reorganization or final liquidation.

Switzerland Rescue of Union Financiere. Failure of Banque de Gen6ve andthree-week run on banks (1931). Restructuring of Banque PopulaireSuisse (1933). Banque d'Escompte Suisse suspended.

United States Substantial bank failures throughoutthe 1929 to 1933period, culmi-

natingin the bank holiday of March 1933.Yugoslavia Bank runs following Credit Anstalt crisis and German and Hungar-ian suspensions.

NONCRISIS COUNTRIES

Bulgaria Despite the failure of several small banks, there was no general runon the banks. Bulgarian banks appear not to have been severelyaffected by the Austrian and German banking crises. In 1934, thegovernment arrangeda merger of a number of banks, although this

does not appear to have been the result of crisis.Canada Despite a severe economic downturn and a decline in bank profit-

ability, there were no bank failures.Czechoslovakia Heavy domestic withdrawals, but no general panic. Commercial

banks less exposed than their neighbors to the Austrian and Germancrises. Despite exchange controls and substantial write-downs onthe part of banks, there were no large failures and no bank holiday.

Denmark Compared with other countries, commercial bank deposits fell onlyslightly during 1931. There was no general run on the banks and no

suspension of payments by any commercialbank.

Finland A somewhat ambiguous case. There was a reduction in the numberof banks between 1929 and 1933; however, the Economist, in its



680 Grossman

regular reports on Finland, makes practically no mention of the

banking situation.

Greece According to Mazower, "Banking and Economic Development"(pp. 224-25), "what is striking about Greek banks is their avoidance

of the sort of crisis which occurred elsewhere in the Balkans."Though there was a currency crisis and several bank failures, theredoes not appear to have been a major banking upheaval.

Lithuania Despite heavy withdrawals from the commercial banks, there were

no moratoria or legal restrictions on withdrawals. Only one privatebanking firmwas forced to suspend payments as a result of the crisisof 1931.

Netherlands The German banking crisis was severely felt and normal channels of

payment (with Germany) were interrupted. The suspension ofsterling convertibility was also felt. Substantial write-downs of bankcapital, but no major bank suspensions or bank holiday.

Portugal The number of commercial banks increased slightly during the

period 1929 to 1932and, according to Reis, "Portuguese Banking,"one of the distinctive features of the Portuguese economy was the

absence of a banking crisis.

Spain One large bank, Banca de Cataluhia,was liquidated but, according toTortella and Palafox, "Banking and Industry in Spain" (p. 105),

"nothing massive or drastic occurred, no really important banks

suspended payments; no large scale 'salvaging operation' wasrequired."

Sweden The collapse of the Kreuger industrial and financial empire led to

weakness of one large bank (Skandinaviska Kreditaktiebolaget), but

"the events of 1931 had no serious visible repercussions on the

commercial banks." (League of Nations, Commercial Banks, 1925-

33, p. 193). Deposits and assets dropped only slightly between 1930and 1933 (and, in fact, rose from 1929 to 1933).

United Kingdom Despite a sterling crisis in 1931,not one bank failed duringthe period.

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grossman explaining bank stability during the depression

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