Interbank contagion during the Depression and its implications for regulation today

Charles Calomiris, Matthew Jaremski, David Wheelock 12 February 2019

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The financial crisis of 2008-09 heightened interest in how relationships within the financial system can amplify exogenous shocks. Amplification can occur through multiple channels. One channel is counterparty contagion through direct contractual obligations between financial intermediaries. A default by one bank, for example, can impose distress on other firms that hold significant liabilities of the defaulting firm. Furthermore, solvent banks that anticipate withdrawals or an inability to borrow will draw down their interbank balances and thereby reduce aggregate liquidity.

In the recent financial crisis, some observers believed that Goldman Sachs’ exposure to AIG would have caused it to fail if AIG had been permitted to fail. Many also argued that bank hoarding of liquidity alongside the contraction of the interbank lending market caused fire sales of risky assets, which drove their prices lower. However, whether such contractual relations were important in magnifying the recent crisis has been hotly contested. For example, Scott (2012) concludes that contractual contagion was not as important as the effect of correlated positions during the crisis, and Boyson et al. (2014) dispute that the interbank market collapsed for solvent banks during the crisis, or that banks’ fire sales were a systemically important contributor to asset price decline.

Those studies, however, have not proven that liquidity risk related to contractual exposures was irrelevant in the crisis, or that it will not be important in the future. Banks have direct contractual exposures to one another through a variety of channels, including interbank loans and deposits, commercial loan participations, and derivative contracts, and bank regulators are concerned about the systemic risk that may result from such contractual exposures. This concern is most clearly seen through the types of legislation and regulation that have been put in place since 2008. For examples, the Dodd Frank Act of 2010 requires regulators to write rules that limit the credit exposures of banks to one another, and new liquidity regulations, such as the Liquidity Coverage Ratio, comprise part of Basel III prudential regulation. From the perspective of current policy, concerns about counterparty contagion need not be justified by the events of the most recent crisis. 

Contagion during the Great Depression

In our new study (Calomiris et al. 2019), we approach the question of liquidity risk associated with counterparty contagion by examining a historical episode – the Great Depression in the US – a crisis in which it is possible to cleanly identify interbank contractual liquidity risks and assess their contribution to bank failure risk. In the early 20th century, contractual exposures between banks occurred mainly through correspondent relationships, which from a research perspective have the advantage of being readily observable and without the complexity of many types of modern contractual exposures. Most banks maintained deposits with other banks (i.e. their correspondents) for payments and other services, as well as to invest surplus funds or obtain credit. 

Correspondent relationships were both a source of liquidity risk and a means of mitigating liquidity risk. For correspondent banks, interbank deposits were a source of liquidity risk because they could be withdrawn suddenly, putting the correspondent bank in an illiquid position. However, after controlling for exposure to interbank deposit withdrawal potential, network relationships were also a means of mitigating liquidity risk. For example, Calomiris and Mason (1997) find that when faced with deposit withdrawals in 1931-32, Chicago banks borrowed from other banks to replace lost deposits, thus mitigating the need to liquidate assets. Banks that were better known and had a larger network profile were better able to borrow funds when needed.

The interbank system had a ‘core–periphery’ structure, with large banks in New York City, Chicago and other major cities at the core of a system comprised of local, regional and national nodes connecting banks across the country (James and Weiman 2010). Following the Panic of 1907, Congress sought to eliminate panics by establishing the Federal Reserve System in 1913. The System’s founders expected that the Fed would greatly reduce the size and importance of the interbank network, which they believed would have reduced systemic liquidity risk. However, banks did not move their all their deposits to the Fed. Interbank deposit exposures remained large in the aggregate, making up almost $4 billion, or 6.5% of total banking system assets in 1929, and thus were potentially a major source of risk to the banking system.  

We show that important contractual contagion occurred during the Depression, and that it significantly worsened the failure risk of banks by increasing liquidity risk. 

We also consider how the establishment of the Fed altered banks’ incentives to manage their exposures to liquidity risk associated with their position in the interbank network. We find that, before the founding of the Fed, banks managed network liquidity risk by maintaining higher equity relative to assets when their exposure to network liquidity risk was relatively high. After the founding of the Fed, however, correspondent banks were less prudent in their management of liquidity risk. Reduced prudence by the most systemically important banks in the system likely contributed to the banking system’s vulnerability to contagion during the Depression. To explore the role of contagion on bank closure risk during the Depression, we use newly digitized data on the entire US interbank network to define each national bank’s correspondents, local market, and balance sheet, which we use to estimate cross-section and panel regression models of bank closure during the Depression. 

The data indicate that banks were at greater risk of closing when they had more respondents (a proxy for a larger amount of deposits due to respondents, which were a source of liquidity risk from sudden withdrawals). Banks also faced more closure risk if their correspondents closed (presumably because this prevented them from being able to access their own deposits). Moreover, we find that a bank’s closure risk was heightened by bank closures in the local markets served by their correspondents. The results indicate, therefore, that contagion through network ties was a significant source of banking instability during the Great Depression. 

The impact of the Fed

We also examine how the founding of the Fed might have affected banks’ management of network liquidity risks. We identify two separable aspects of network relationships that affected liquidity risk in the pre-Fed era, consistent with the fact that network relationships could be either a source of liquidity risk or a means of mitigating liquidity risk. One aspect (the amount of deposits due to respondents) created liquidity risk, and the other (the total number of network relationships, which we interpret as a measure of the bank’s reputation and credit worthiness within the network, and thus its ability to access resources) mitigated liquidity risk. After controlling for the amount of deposits due to respondents, which would tend to increase risk, the size of a bank’s respondent network – i.e. the number of respondents the bank had – should ordinarily mitigate liquidity risk. 

We find that before the Fed was established, both aspects affected how banks managed their portfolio risk and leverage. Greater exposure to interbank deposits encouraged banks to increase their capital ratios, while more network relationships (holding constant the amount of interbank deposits) led them to hold lower cash and capital ratios. By contrast, after the Fed was established, correspondent banks appear less sensitive to network liquidity risk. We find that both aspects of network connections had much less impact on banks’ risk management decisions in the years after the Fed’s founding, suggesting that expected access to liquidity from the Fed reduced cross-sectional differences in perceived liquidity risk for correspondent banks, which likely heightened contagion risk through the interbank network. In essence, the founding of the Fed provided a perception of liquidity risk insurance against the sorts of shocks associated with banking panics in the National Banking era, and in so doing weakened the incentives for correspondent banks to guard against interbank liquidity risks by holding more capital or liquid assets. 

The Depression was an extremely adverse event that produced losses and increased risks that overwhelmed the risk management precautions that banks had undertaken in the form of capital and liquid asset buffers. As banks’ insolvency risks rose, withdrawal pressures from other banks and the inability to access liquidity held at failing banks both magnified liquidity risk and contributed to bank failure risk. Compounding the problem, prior to the crisis, systemically important banks acted as though they expected the Fed to provide liquidity risk insurance that had not existed before the Fed’s founding. After the founding of the Fed, correspondent banks no longer perceived a need to hold extra capital or liquidity against systemic risk in the interbank network. Thus, when the Fed failed to deliver on the promise of the System’s founders that the central bank would end the problem of banking panics, banks were even more exposed to network liquidity risk than they would have been in pre-Fed days. 

Policy implications

The lessons for today’s policymakers are clear. First, interbank contractual connections can pose significant liquidity risks to banks during a crisis. Second, safety net policies, including the lender of last resort, may lead banks to be less cautious in their management of liquidity risk. Both of these lessons provide a foundation for regulatory policies that take account of potential contractual contagion, and that require minimum prudential capital and liquidity buffers to take those risks into account.

References

Boyson, N, J Helwege, and J Jindra (2014), "Crises, Liquidity Shocks, and Fire Sales at Commercial Banks," Financial Management 43 : 857-884.

Calomiris, C W and J R Mason (1997), “Contagion and Bank Failures During the Great Depression: The June 1932 Chicago Banking Panic”, American Economic Review 87(5): 863-83.

Calomiris, C W, M Jaremski, and D C Wheelock (2019), “Interbank Connections, Contagion and Bank Distress in the Great Depression,” Federal Reserve Bank of St. Louis Working Paper 2019-001A.

James, J A and D F Weiman (2010), “From Drafts to Checks: The Evolution of Correspondent Banking Networks and the Formation of the Modern U.S. Payments System, 1850-1914”, Journal of Money, Credit and Banking 42: 237-65.

Scott, H S (2012), "Interconnectedness and Contagion", Committee on Capital Markets Regulation, 20 November. .

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Topics:  Economic history Financial regulation and banking

Tags:  interbank contagion, liquidity risk, Great Depression, crisis

Henry Kaufman Professor of Financial Institutions, Columbia University Graduate School of Business

Associate Professor of Economics and Finance, Utah State University

Vice President and Deputy Director of Research, Federal Reserve Bank of St. Louis

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