The current global financial crisis grew out of banking losses in the United States related to subprime lending. How well do economists understand the origins of such crises and how they spread? Was this crisis something new or a replay of familiar historical phenomena? Will policy interventions be able to mitigate its costs ? The history of banking crises provides informative perspectives on these and other important questions.
Crises Are Not All the Same
When considering the history of banking crises, it is useful to distinguish between two phenomena associated with banking system distress: exogenous shocks that produce insolvency, and pressures on banks that arise from rapid withdrawals of debt or failures to rollover debt during "panics." These two contributors to distress often do not coincide. For example, in the rural United States during the 1920s, large declines in agricultural prices cause many banks to fail, often with high losses to depositors, but those failures were not associated with systemic panics. (2) In 1907, the opposite pattern was visible. The United States experienced a systemic panic, originating in New York, which was precipitated by small aggregate shocks but had large short-term systemic effects associated with widespread withdrawals of deposits. Although some banks failed in 1907, failures and depositor losses were not much higher than in normal times. (3) That crisis was resolved only after banks had suspended convertibility and after uncertainty about the incidence of the shock had been resolved.
The central differences between these two episodes relate to the information about the shocks producing loan losses. In the 1920s, the shocks were loan losses in agricultural banks, geographically isolated and fairly transparent. Banks failed without subsequent system-wide concerns. During 1907, although the ultimate losses for New York banks were small, the incidence of the shock was not clear (loan losses reflected complex connections to securities market transactions, with uncertain consequences for some New York banks).
Sometimes, large loan losses and confusion regarding their incidence occur together. In Chicago in mid-1932, for example, large losses resulted in many failures and also in widespread withdrawals from banks that did not ultimately fail. Despite the confusion about the incidence of the shock, and the consequent widespread temporary disruptions to the financial system, the banks that failed were exogenously insolvent; solvent Chicago banks experiencing withdrawals did not fail. In other episodes, however, bank failures may have reflected illiquidity resulting from runs, rather than exogenous insolvency. (4)
Today's financial turmoil is closer to the Chicago experience in 1932 than to either the banking shocks of the 1920s or those of 1907. (5) The shock that prompted the turmoil was of moderate size (subprime and Alt-A loans totaled roughly $3 trillion, including those on the balance sheets of Fannie Mae and Freddie Mac, and total losses are likely to generate total losses of roughly half a trillion dollars), and its consequences were significant for both solvent and insolvent banks. Unlike the Chicago Panic, today's turmoil probably has produced the failures of financial institutions that were arguably solvent prior to their liquidity problems (for example, Bear Stearns).
Banking crises can differ according to whether they coincide with other financial events. Banking crises coinciding with currency collapse are called "twin" crises (as in Argentina in 1890 and 2001, Mexico in 1995, and Thailand, Indonesia, and Korea in 1997). A twin crisis can reflect two different chains of causation: an expected devaluation may encourage deposit withdrawal to convert to hard currency before devaluation (as in the United States in early 1933); or, a banking crisis can cause devaluation, either through its adverse effects on aggregate demand or by affecting the supply of money (when a costly bank bailout prompts monetization of government bailout costs). …