U.S. Banking Crises: What Was the Same? What Was Different?

Financial Crisis

• A major disruption in financial markets characterized by sharp declines in asset prices and the failures of many financial and non financial firms.

Source: Mishkin and Eakins

• Financial historians have documented events leading up to the United States’ financial crises over the years.

• There are similarities between the stresses and setbacks that have occurred in the financial markets.

Banking and Financial Crisis Timeline

• 1782: Bank of the United States is Chartered: This marked the beginning of commercial banking in the United States.

1782

Banking and Financial Crisis Timeline

• 1791: Bank of the United States is chartered. This was our first attempt to have a federally chartered bank.

1782 1791

Banking and Financial Crisis Timeline

• 1811: Bank of the United States’ charter was allowed to lapse. Agricultural and other interests were suspicious of centralized power. The political pressure by this group led to the elimination of the first Bank of the United States.

1782 1791 1811

Banking and Financial Crisis Timeline • 1816: Second Bank of the United States is Chartered.

1782 1791 1811 1816

Banking and Financial Crisis Timeline • 1819: First major financial crisis in the United States. This crisis is said to have

resulted from the Embargo Act of 1807 and the War of 1812. The U.S. Government borrowed heavily to finance the War of 1812, which caused a strain in bank reserves. When it became clear that the monetary situation was threatening, it spurred a wave

of bank runs and bank failures.

1782 1791 1811 1816

1819

Banking and Financial Crisis Timeline • 1832: Second Bank of the United States Charter was allowed

to lapse.

1782 1791 1811 1816 1832

1819

Banking and Financial Crisis Timeline • 1830’s: Period of “free banking.” Anyone who met rather easy

conditions could organize a bank and issue bank notes as well as take deposits. Many new banks organized and issued their own banknotes. It became difficult to differentiate between genuine and counterfeit notes, or

even notes on non-existent banks.

1782 1791 1811 1816 1832

A few banks (called the “wildcat banks”) made it hard to present theirbanknotes to them for redemption by locating in out of the way places,like the sticks, where the wildcats lived. Some less common bank notescirculated at less than face value. Bank failures, too, were common.

1819

Banking and Financial Crisis Timeline • 1837: Financial crisis of 1837 was preceded by an economic

expansion from mid 1834-1836. When the land bubble collapsed, the financial strain began. Speculative lending practices were part of this crisis.

1782 1791 1811 1816 1832

1819 1837

•The US acquired significant financing from Great Britain.

•The lending boom whose source was British credit financed much of the

US’ westward expansion and industrial growth in the Antebellum era.

Banking and Financial Crisis Timeline

• 1857: triggered by the failure of “Ohio Life Insurance and Trust Company.” This was an Ohio based bank with large mortgage holdings. Ohio life failed due to fraudulent activities by bank managers. Its failure led to widespread bank panics and losses.

1782 1791 1811 1816 1832

1819 1837 1857

The 1850’s were a period of prosperity. However, by 1857, the Europeandemand for American goods declined, leading to business failures and financialpanic ensued.

Banking and Financial Crisis Timeline • 1863: National Currency Act of 1863. Congress established

the National Banking System. Now, the federal government could charter national banks, which issued uniform bank notes.

1782 1791 1811 1816 1832 1863

The notes were safe because each national bank had to deposit $10 of federal government bonds with the Comptroller of the Currency for each$9 of bank notes it issued. If a bank failed, the holders of its national bankNotes were repaid by the Comptroller of the Currency out of bonds the bankhad deposited with it.

1819 1837 1857

Banking and Financial Crisis Timeline

• Financial Crises: 1873, 1884, 1893• Bonds and stocks had been issued for purpose of building railroads.

Credit had been extended until a point was reached where people questioned the intrinsic value of the securities. Railroads were overbuilt. Fraud was apparent in the building of some railroads.

1782 1791 1811 1816 1832 1863

1873-1879: Longest Recession in US history lasted from October 1873-March 1879The recession is said to have been “triggered” by financial crisis of 1873.

1873 1884 1893 1819 1837 1857

Banking and Financial Crisis Timeline

• Crisis of 1907:

• An Earthquake in 1906 in San Francisco created massive liquidity problems for banks.

• A severe recession began June 1907. This recession is said to have led to the circumstances that led Congress to create the Federal Reserve.

1782 1791 1811 1816 1832 1863

1873 1884 1893 1907

There was a 6 week stretch of bank runs in October and November of 1907.

1819 1837 1857

Banking and Financial Crisis Timeline

• 1913: Federal Reserve Act of 1913 creates the Federal Reserve System. The Federal Reserve resembles the U.S. Constitution because many checks and balances were built into its structure.

1782 1791 1811 1816 1832 1863 1913

1873 1884 1893 1907

The Federal Reserve System was created to (1) control the volume of moneyIn circulation (b) administer monetary policy (c ) act as a lender of the last resort(d) perform the government’s banking functions, (e) serve as a banker’s bank and (f) regulate banks and other financial institutions.

1819 1837 1857

Banking and Financial Crisis Timeline • 1929: The stock market crashed in 1929 and was followed by

the Great Depression.

1782 1791 1811 1816 1832 1863 1913

1873 1884 1893 1907 1929

The 20’s were a period of excess and wealth. The stock market had seen a 9 year period where the Dow Jones Industrial Average increased tenfold andpeaked on September 3, 1929. Despite the dangers of speculation, many had believed the stock market would rise indefinitely. The market crashed on September 18, 1929.

1819 1837 1857

Banking and Financial Crisis Timeline

• 1933: Banking Act of 1933: Created the Federal Deposit Insurance Corporation (FDIC). It insured each depositor at a bank up to a loss initially set at $2,500 per deposit. Currently, depositors are insured against losses up to $250,000!

• This act also prevented banks from underwriting or dealing in corporate securities. This act separated the activities of the banking industry and the securities industry.

1782 1791 1811 1816 1832 1863 1913 1933

1873 1884 1893 1907 1929

From 1930-1933, the number of bank failures averaged over 2,000 per year. After theEstablishment of the FDIC, bank failures averaged fewer than 15 per year until 1981.Historical FDIC Insurance Levels:1934: up to $2,500 1969: Up to $20,0001935: up to $5,000 1974: Up to $40,0001950: Up to $10,000 1980: Up to $100,0001966: Up to $15,000 2008: Up to $250,000

1819 1837 1857

Banking and Financial Crisis Timeline

• 1984: Financial innovation and deregulation led to this crisis.• A greater percentage of loans were put into real estate and loans to finance corporate

takeovers and leveraged buyouts. • The 1982 Bank Act allowed thrift institutions to allocate more excess reserves to

commercial real estate (up to 40%) and junk bonds (10%)• Moral Hazard: The FDIC raised the insurance threshold to $100,000 per deposit. Some

believe this distorted bank managers’ incentives to “play things safe.” • Failure of the nation’s 8th largest bank (Continental Illinois) in 1984 was followed by the

failure of other large banks.1782 1791 1811 1816 1832 1863 1913 1933 1984

1873 1884 1893 1907 19291819 1837 1857

There was a burst of financial innovation in the 60’s, 70’s and early 80’s. •Money market mutual funds•Commercial paper•Financial futures•Junk bonds•SwapsSome banks sought out riskier financial investments because the financial innovation wave decreased profitability of traditional bank business.

Banking and Financial Crisis Timeline

• 2008: Considered the worst financial crisis since the Great Depression. This crisis was related to the bursting of the U.S. housing bubble, which peaked in 2006. Economies worldwide slowed significantly.

1782 1791 1811 1816 1832 1863 1913 1933 1984

1873 1884 1893 1907 1929 2008

1819 1837 1857

This crisis was triggered by policies that encouraged home ownership by providingeasier access to loans for sub-prime borrowers. Complex financial products and theovervaluation of bundled subprime mortgages led to the financial collapse. The “September to Remember” (September 2008) threatened the total collapse of largefinancial institutions. The stock market turned down and decreased household wealth by trillions of US dollars.

U.S. Home Prices Over Time

Key Observations About Crises

• (1) Financial crises have happened throughout history. They’re not something “new.”

• (2) The interval of time between crisis years is irregular, but occur, on average, every 20 years.

• (3) Crisis years and recession years are not mutually exclusive.

• (4) Stages of the crises usually follow a pattern.• Lending boom• Inadequate expertise to assess risk by bankers and

regulators• Massive loan losses• Government Bailout or New Regulations

A Success Story

• Black Monday Stock Market Crash of 1987:

On October 19, 1987, the U.S. experienced a huge decline in the stock market. The Dow Jones Industrial Average declined by more than 20%. Banks in the U.S. and abroad grew nervous about the financial health of securities firms. The Fed feared the collapse of securities firms so they announced that they were wiling to serve as a source of liquidity to the financial system. The FED extended discount loans to any bank that would make loans to the securities industry. The Fed’s message was, “We’re here. Whatever you need, we’ll give you.” The timely action averted a financial panic.

– Source: Financial Markets and Institutions, Frederic S. Mishkin and Stanley G. Eakins, 6th edition, pp. 182.

Another Success Story• September 11, 2011

The community was in shock on September 11, 2011, when terrorists struck the World Trade Center. To satisfy the liquidity needs and keep the financial system from collapse, the Fed made an immediate announcement similar to that of the crash of 1987. The Fed stated, “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” In fact, the Fed pumped over a 200-fold increase over the previous week in discount loans to banks and added $80 billion in reserves into the banking system through open market operations.

-Source: Source: Financial Markets and Institutions, Frederic S. Mishkin and Stanley G. Eakins, 6th edition, pp. 182.

Conclusions

• Commercial banks are for profit institutions, in addition to being a key intermediary that brings the borrows and lenders together which is critical for economic growth.

• Like any profit making institution, banks develop new products to satisfy their needs for revenues as well as the needs of customers.

• Financial innovation, which can be beneficial to the economy can be (and usually is) driven by the desire to get rich.

• Banks are among the most highly regulated institution in the world.

• Even in the midst of much examination and regulation, banks can and do fail and when they do, it becomes costly.