Are Branch Banks Better Survivors? Evidence from the Depression Era

By Carlson, Mark | Economic Inquiry, January 2004 | Go to article overview

Are Branch Banks Better Survivors? Evidence from the Depression Era


Carlson, Mark, Economic Inquiry


I. INTRODUCTION

In recent years, branch banking has been promoted as a way of increasing the stability of the banking system. The reasoning is straightforward. Branching facilitates geographic diversification. Diversification in turn reduces the risk that a geographically focused idiosyncratic shock will affect a bank severely enough to cause it to fail. This has been noted both historically, by Southworth (1928), and in the recent literature, for example by Gart (1994). The promise of increased stability was one of the reasons for recent legislation (such as the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994) deregulating the banking sector to allow branching.

While the creation of branch bank networks has been heralded as a source of stability, the lack of branch banking has often been blamed for the prevalence of banking crises in the United States. Friedman and Schwartz (1963) blamed the high failure rate of U.S. banks during the Depression on the lack of branching. Recent work by Grossman (1995) suggested that countries with extensive branch networks were less likely to experience a banking crisis in the 1930s. Focusing on a more modern crisis, Gart (1994) suggested that interstate branching might have mitigated the large losses of the savings and loan crisis of the 1980s.

This article tests the conventional wisdom that allowing banks to establish branches increases their ability to withstand shocks and reduces failures within the banking sector. Specifically I test whether branching increased the length of survival of individual banks in the Great Depression. By using individual banks, I am able to separate the effect of branching from effects of associated characteristics, such as bank size. The first four years of the Depression are used because this is the most recent period in the United States where both unit and branch banks existed, large numbers of banks failed, and the debate over branching features prominently in the literature on this period.

The results are striking. Branch banks are found to be less likely to survive and to survive for shorter periods of time. Because these results are so different from those of previous work, additional investigation is undertaken to determine why they are obtained.

Branching allows banks to diversify their assets by improving access to different industries that may respond to shocks differently, as in Gart (1994), and by reducing exposure to spatially concentrated shocks, which might be especially important in agricultural regions, as noted by Southworth (1928) and Wheelock (1995). White (1984) argues that branching also allows banks to diversify their liabilities by expanding the pool of depositors, which, as long as depositors who differ by location also differ in their behavior, may reduce deposit volatility. The conventional wisdom in the literature is that banks used this diversification to reduce the level of risk to which they were exposed. As suggested by Hughes et al. (1996), however, this diversification allows banks to reoptimize their portfolios. Banks can either accept a lower level of risk and the same level of profits or they can increase their profits and maintain the same overall risk level by increasing the risk associated with individual loans and reducing the cash reserves used to meet deposits. Although changes in both the risk associated with loan portfolios and the ratio of liquid reserves to deposits likely affected bank performance during the Depression, the explanation developed here focuses on the reserve to deposit ratio. (1)

I hypothesize that banks choose the amount of reserves held to meet deposit withdrawals, or the level of liquidity risk. Branch banks have a different risk-return trade-off, because they are able to diversify away idiosyncratic withdrawals and smooth the level of deposits. Because of this different trade-off, branch banks hold fewer reserves and more loans than unit banks. …

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