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Banking during the Great Depression: The good news
Daniel Gros
1 May 2009
Today’s general consensus is that a key factor behind the Great Depression was the breakdown of
the US banking system and that we must avoid large-scale bank failures this time around at all
costs. However, this column shows that commercial banks actually do relatively well during
recessions. It is the financial sector outside banking – in other words, investment banking – that
suffers huge losses.
Every student of money and banking is told that a key factor leading to the Great Depression was
the breakdown of the US banking system. However, a closer look at the numbers shows a surprising
resilience of the banking system, which continued to make profits even at the bottom of the
Depression, whereas most other sectors made losses.
Bank failures
There is a general consensus today that we must do everything possible to avoid large-scale bank
failures, and that this was not done during the 1930s. However, the impact of the widespread
failures that took place then was much more limited than is generally assumed.
The number of bank failures rose from an annual average of about 600 during the 1920s to 1,350 in
1930 before peaking in 1933 when 4,000 banks were suspended. Over the entire period 1930-1933,
one-third of all US banks failed. However, deposit losses remained limited even during this turbulent
period at a cumulative 4% (with an annual peak of 2.15% in 1933) of total deposits (of all
commercial banks). How can one reconcile these relatively modest losses with the large number of
bank failures?
Table 1. Commercial bank suspensions during the Great Depression
Year
Average
Number of
Suspensions
Deposits
(millions
Losses Borne
by Depositors
of USD)
(millions of
USD)
Losses as
Loss
% of
rate
deposits
in %
631
174
61
0.15
35
1929
659
231
77
0.18
33
1930
1350
837
237
0.57
28
1931
2293
1690
390
1.01
23
1932
1453
706
168
0.57
24
1933
4000
3597
540
2.15
15
1921-28
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Cumulative
1930-33
9096
6830
1337
4.3
20
Source: FDIC
One reason why losses to depositors were ultimately quite limited is that, even in failed banks,
depositors still received about 80 cents on the dollar, on average.1
Another key reason was that the degree of concentration in the banking industry was much lower
then than it is today. In the mid-1930s, the top three banks held about 11% of the total assets of
the industry; in 2008 they held about 40%. Although about one-third of all banks failed between
1930 and 1933, they accounted for only about 20% of all deposits.
The downside of this fragmentation of the banking sector was that few institutions were regarded as
systemic. The failure of any one of the numerous “mini” banks did thus not arouse particular
concern. Hence little was done to prevent the numerous bank failures that did occur. However, the
continuing latent, if actuarially relatively small, risk of banks undermined confidence. Given the
absence of a federal deposit insurance system, this undermined the functioning of the banking
system as banks had to be extremely cautious given the potential for runs (mass withdrawals). The
negative feedback loop that operates today – weakness of demand leading to more firms failing and
hence bank losses – was thus amplified by the lack of an effective deposit insurance system and a
generally higher willingness to allow banks to fail.
The need for a federal deposit insurance system in the US was one key lesson learnt, and the
creation of the FDIC as part of the New Deal certainly contributed to the recovery. The lesson that
confidence of depositors in the banking system is crucial has been amply applied in Europe during
the present crisis, when EU governments expanded the existing deposit insurance systems to cover
the holes that the Northern Rock episode exposed.
The US authorities had to relearn this lesson after the Lehman debacle. Given the large impact of the
modest deposit losses during the 1930s, it should not have come as surprise that a failure of this
size should have extreme consequences. As an investment bank, Lehman did not have any deposits
from the general public, but its assets of about $660 billion were equivalent to about 5% of the
entire US banking system.
Moreover, Lehman alone constituted a major part of the bank bond market, as it had issued about
$600 billion of short- and long-term bonds, for a total of about $1200 billion emitted by all
commercial banks together.
Can banks survive a depression?
The Great Depression certainly led to a collapse in corporate profits. The corporate sector went from
profits amounting to over $10 billion (about 10% of GDP) in 1929 to a collective loss of about $1.5
billion (about 2.5% of GDP) in 1932 (see table 2).
Table 2. Corporate Profits before tax, million USD
1929
Total Corporate
Domestic
1930 1931 1932 1933 1934 1935
10595 4291
357
1480
1728 3079 4216
industries
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(including
financial
industry)
Finance, insurance, and
real estate
Banking
10363 4154
361
1446
1730 3019 4057
1760
771
473
361
463
236
318
1003
796
675
576
536
422
466
Source: BEA
Oddly enough, in the banking sector, which is thought to have been the most affected by the crisis,
profits stayed positive throughout this period. Bank’s profits declined by “only” a little more than
40%, more or less in line with nominal GDP. Figure 1 shows that bank’s profits were indeed relatively
stable as a proportion of GDP (just below 1% of GDP).
Figure 1. Profits in US during the 1930s (before tax as % of GDP)
Source: BEA
However, the financial sector outside banking did suffer losses. Banks thus appear to have been an
island of relative stability. The run-up to and aftermath of the current crisis show similar features,
with corporate profits buoyant before the crisis but collapsing with the onset of the bust. This boomand-bust pattern is also pronounced in the financial sector outside banking.
The data for the last 25 years displayed in Figure 2 show that in general banking profits display little
correlation with GDP growth. This property is shared neither by the rest of the financial sector nor
the corporate sector as whole.
Figure 2. Profits in US after 1980 (before tax)
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Source: BEA
As most observers tend to lump banks and the larger financial sector together, it is widely assumed
that banks’ profits also increased during the last boom. However, this was not the case. The profits
of (commercial) banks as measured by national accounts did not noticeably increase up to 2007. The
data from the Great Depression suggest that banks might be more resilient than the wider financial
sector.
Another reason for the widespread impression of large profits in banking might be the confusion
between the national income accounting concept and the numbers reported in financial statements.
The national income accounts do not “mark to market”. Financial transactions and capital gains and
losses related to transactions of financial securities are thus not included in the national accounts.
During the boom phase, profits in the national income accounts tend thus to be lower than those
reported to financial markets (and vice versa during the bust). Profits as measured by the national
accounts should thus give a better picture of underlying, operating profitability of the sector.
The recent batch of relatively reassuring profits reported by many US banks can also be understood
in the light of switch away from mark-to-market accounting. That most banks can report positive
profits resembles the experience of the Great Depression.
How can one explain the relative stability of banks’ profits in general and in particular during the
Great Depression? Simply put, it seems that banks are on average able to charge enough of a risk
premium to cover the increase in non-performing loans during downturns. The present crisis
confirms this tendency. Much has been made of the IMF’s recent headline estimate of over $4trillion
in aggregate losses to the financial sector expected from the present crisis. However, this figure is an
estimate of the total over four years (2007-10), and banks account for only about 60% of the overall
amount. Moreover, about one-half of the losses expected by banks ($2.4 trillion, see table 1.3 of the
Global Financial Stability Report, April 2009) derive from the markdown of securities (which would
not be included in national income accounts).
The global average overall loss rate on loans for banks is estimated to be around 5.1%. Given that
this is assumed to be the cumulated loss rate over four years, banks should be able to absorb it with
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a commensurate increase in their spreads. If the losses accrue mostly towards the end of this period,
an increase in the average spread applied by banks of less than 2%should be sufficient to keep
banks (on average at least) from making large losses. Banks do appear to be charging such spreads.
For example, the ECB reports that the rates charged by euro area banks to corporate customers are
now around 4.8%; about 2.5% – 3%higher than marginal funding costs as measured by Euribor
rates or the rates paid on savings deposits. In the US the ‘prime rate’ (the rate charged by banks to
their best customers) is at 3.25%; about 3% above marginal funding costs embodied in the federal
funds or the commercial paper rates. This should be sufficient to deal with the losses that can be
expected even under the current economic conditions.
Despite its much greater severity, the Great Depression did not actually lead to much higher loss
rates. As shown in figure 1.30 of the IMF’s Global Financial Stability Report, commercial bank loan
charge-offs peaked for only one year at a bit above 5%, but the average for the early 1930s
remained between 2 and 3%.
Concluding remarks
The resilience of “normal” banking operations to a recession or even a depression strengthens the
case for a separation of commercial and investment banking activities. The classic banking
operations of deposit-taking and lending tend to remain profitable even under stressed conditions.
But this classic function of banking would not be such a cause of concern today if the investment
banking arms of banks had not gotten into trouble by investing in “toxic” assets. At present, the
authorities in both the US and Europe have little choice but to make up for the losses on “legacy”
assets and wait for banks to earn back their capital. But to prevent future crises of this type,
policymakers should make sure that losses from investment banking arms cannot impair commercial
banking operations.
References
Federal Deposit Insurance Corporation (FDIC) (1998), A brief history of deposit insurance in the US
IMF (2009) Global Financial Stability Report (GFSR), Responding to the Financial Crisis and
Measuring Systemic Risks, April
1 Between 1908 and 1917, eight states established deposits insurance funds but by end of the 1920s
they had all failed (FDIC, 1998)
This article may be reproduced with appropriate attribution. See Copyright (below).
Topics: Financial markets
Tags: Great Depression, banks, investment banking
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