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The Banking Crisis - History

The Banking Crisis - History


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The Great Depression did not begin with a crisis in American banks. However, the financial crisis soon spread to banks. Bank after bank was forced to close, as one after another suffered a run on their bank. The worst year for the banks was 1931 when 2, 298 banks failed. In 1932, the situation had gotten better after Congress established the Reconstruction Finance Corporation to give emergency loans to banks. Still, as 1933 dawned, the state of US banks continued to worsen. Key banks were on the verge of failure. The banks in Detroit were saved only by a bank holiday.
Unfortunately, the period between the election and the time that the new President was sworn in was better suited for the days of the horse and not the modern world. Roosevelt's election had been in early November and Inauguration Day was not until March 4th. The country and the banks desperately wanted to hear assurances from Roosevelt what he was planning to do. The situation was getting more perilous by the day, and the world wanted to hear from the new President.

Roosevelt declined to make these commitments. Roosevelt refused because he believed there could only be one President at a time. Furthermore, FDR did not think the policies advocated by Hoover were correct. In the meantime, the contagion that hit the banks in Detroit did indeed spread to neighboring states. Millions of dollars were being pulled out of the banks each week.


The crisis appeared to deepen as inauguration day approached. In the end, 32 states closed at least some of their banks. In the waning hours of the Hoover Administration, his advisors, together with members of the incoming Roosevelt administration, tried to convince Hoover to declare a bank emergency and close all the banks. Hoover refused. He blamed the acute crisis on Roosevelt. Finally, in the wee hours of the morning before the inauguration, the incoming and outgoing Treasury Secretaries managed to convince the State Governors of each of the states with open banks to close them.

As Inauguration Day dawned, the people of Washington, DC woke to a cold and cloudy day. Word slowly spread that all the banks in the country were closed. People would have to make good solely with the cash they had in hand. At noon, Roosevelt took the oath of office. Roosevelt promptly began what is considered one of the most famous inaugural addresses. In it, FDR stated the memorable line: "The only thing we have to fear, is fear itselfî. His speech stirred the audience and gave hope to a country that had begun to feel hopeless.
Roosevelt was ready to implement a plan developed by his incoming Secretary of the Treasury, William Woodin, together with Hooverís outgoing Secretary of Treasury, Ogden Mills. Their three action points were: requesting a proclamation by the President, pursuant to the statue known as the ìTrading with the Enemies Actî to close all the banks; the second, calling a special session of Congress to enact legislation to strengthen the banking system; and the third, initiating a meeting with major bankers.

The closure of the banks, however, caused significant hardships. It was estimated that the average Bostonian had approximately $18 in hand when the banks closed. Without access to their money, the ability to cash checks, or even make change, businesses would quickly grind to a complete halt. People might starve. The government soon modified the closure of the banks to allow them to make change, cash government checks, and provide money for food and emergencies. In the meantime, work was proceeding at a rapid pace to present Congress with an Emergency Banking Bill. The bill was submitted to Congress on Thursday, March 9th, five days after the Rooseveltís inauguration.

The bill had four major provisions. First, the bill ratified the actions of the President in closing the banks. It also gave the President the authority to regulate the whole banking sector. Second, the bill gave the controller of the currency the power to appoint a receiver to take over any bank that was too weak to reopen. Third, the bill allowed banks to issue preferred shares and RFC to purchase. Finally, the law authorized the issuance of Federal Reserve Bank notes to provide additional liquidity to the banking system. The Emergency Banking Bill was introduced at 11 AM in the morning. At 8 PM, it was on the Presidentís desk for signature.

All of these measures would not be enough unless the public believed the banks that would reopen soon were sound. That job fell on the President. On Sunday, March 12th, President Roosevelt gave the first of what would become known as his"Fireside Chat" addresses.

The medium was the radio. At 10 PM, Roosevelt began his address. FDR started his speech by saying: "My friends, I want to talk for a few minutes to the people of the United States about banking. He went on to give a brief history of the crisis. Most importantly, FDR assured the American people that any bank that reopens would be sound; otherwise, the government would not allow it to reopen. Roosevelt urged the American people not to remove any more money from the banks, and even to return the money they had pulled out.

Franklin Delano Rooseveltís first "Fireside Chat"speech was probably the most successful speech in American history. The next day, when the first banks reopened, lines appeared, not to withdraw money, but to deposit it. The banking crisis was over. The swift actions of the Treasury Department, the Congress and, most importantly, the reassuring rhetoric of the President had ended this crisis.


The Evolution of Banking Over Time

Banking has been around since the first currencies were minted—perhaps even before that, in some form or another. Currency, in particular coins, grew out of taxation. As empires expanded, functional systems were needed to collect taxes and distribute wealth.

Key Takeaways

  • Banking institutions were created to provide loans to the public. As economies grew, banks allowed members of the general public to increase their credit and make larger purchases.
  • Historically, temples were considered the earliest forms of banks as they were occupied by priests and became a haven for the wealthy.
  • The earliest Roman laws allowed for the taking over of land in lieu of loan payments that were owed between debtors and creditors.
  • A well-known economist, Adam Smith, theorized during the 18th century that a self-regulated economy, known as "the invisible hand," would allow for markets to reach equilibrium.  
  • The panic of 1907 was a trigger of two brokerage firms that had become bankrupt causing a recession when liquidity was was restricted. This led to the creation of the Federal Reserve Bank.  

Banking Panics of the Gilded Age

The late 19th century saw the expansion of the US financial system but was also beset by banking panics.

The Gilded Age in US history spans from roughly the end of the Civil War through the very early 1900s. Mark Twain and Charles Dudley Warner popularized the term, using it as the title of their novel The Gilded Age: A Tale of Today, which satirized an era when economic progress masked social problems and when the siren of financial speculation lured sensible people into financial foolishness. In financial history, the term refers to the era between the passage of the National Banking Acts in 1863-64 and the formation of the Federal Reserve in 1913. In this period, the US monetary and banking system expanded swiftly and seemed set on solid foundations but was repeatedly beset by banking crises.

At the time, like today, New York City was the center of the financial system. Between 1863 and 1913, eight banking panics occurred in the money center of Manhattan. The panics in 1884, 1890, 1899, 1901, and 1908 were confined to New York and nearby cities and states. The panics in 1873, 1893, and 1907 spread throughout the nation. Regional panics also struck the midwestern states of Illinois, Minnesota, and Wisconsin in 1896 the mid-Atlantic states of Pennsylvania and Maryland in 1903 and Chicago in 1905. This essay details the crises in 1873, 1884, 1890, and 1893 this set includes all of the crises that disrupted or threatened to disrupt the national banking and payments system. A companion essay discusses the Panic of 1907, the shock that finally spurred financial and political leaders to consider reforming the monetary system and eventually establish the Federal Reserve.

The Panic of 1873 arose from investments in railroads. Railroads had expanded rapidly in the nineteenth century, and investors in many early projects had earned high returns. As the Gilded Age progressed, investment in railroads continued, but new projects outpaced demand for new capacity, and returns on railroad investments declined. In May and September 1873, stock market crashes in Vienna, Austria, prompted European investors to divest their holdings of American securities, particularly railroad bonds. Their divestment depressed the market, lowered prices on stocks and bonds, and impeded financing for railroad firms. Without cash to finance operations and refinance debts that came due, many railroad firms failed. Others defaulted on payments due to banks. This turmoil forced Jay Cooke and Co., a notable merchant bank, into bankruptcy on September 18. The bank was heavily invested in railroads, particularly Northern Pacific Railway.

A cartoon of a giant figure named 'Panic' clearing garbage on Wall Street, 1873 (Library of Congress Prints and Photographs Division, LC-DIG-ds-04513)

Cooke’s failure changed expectations. Creditors lost confidence in railroads and in the banks that financed them. Stock markets collapsed. On September 20, for the first time in its history, the New York Stock Exchange closed. Trading did not resume for ten days. The panic spread to financial institutions in Washington, DC, Pennsylvania, New York, Virginia, and Georgia, as well as to banks in the Midwest, including Indiana, Illinois, and Ohio. Nationwide, at least one-hundred banks failed.

Initially, the New York Clearing House mobilized member reserves to meet demands for cash. On September 24, however, it suspended cash payments in New York. New York’s money center banks continued to supply cash to country banks. Those banks fulfilled withdrawal requests by drawing down reserves at banks in New York and in other reserve cities, which were municipalities whose banks could hold as deposits the legally required cash reserves of banks in other locations. The crisis subsided in mid-October.

The Panic of 1884, by contrast, had a more limited impact. It began with a small number of financial firms in New York City. In May 1884, two firms – the Marine National Bank and the brokerage firm Grant and Ward – failed when their owners’ speculative investments lost value. Soon after, the Second National Bank suffered a run after it was revealed that the president had embezzled $3 million and fled to Canada. Then, the Metropolitan National Bank was forced to close after a run was sparked by rumors that its president was speculating on railroad securities with money borrowed from the bank (those allegations later proved to be untrue).

The latter institution had financial ties to numerous banks in neighboring states, and its closure raised doubts about the banks to which it was linked. The crisis spread through Metropolitan’s network to institutions in New Jersey and Pennsylvania, but the crisis was quickly contained. The New York Clearing House audited Metropolitan, determined it was solvent, advertised this fact, and loaned Metropolitan $3 million so that it could withstand the run. These actions reassured the public, and the panic subsided.

The Panic of 1890 was also limited in scope. In November, after the failure of the brokerage firm Decker, Howell and Co., securities’ prices plunged. The firm’s failure threatened its bank, the Bank of North America. Depositors feared the bank would fail and began withdrawing substantial sums. Troubles began to spread to other institutions, including brokerage firms in Philadelphia and Richmond. Financier J.P. Morgan then convinced a consortium of nine New York City banks to extend aid to the Bank of North America. This action restored faith in the bank and the market, and the crisis abated.

The Panic of 1893 was one of the most severe financial crises in the history of the United States. The crisis started with banks in the interior of the country. Instability arose for two key reasons. First, gold reserves maintained by the US Treasury fell to about $100 million from $190 million in 1890. At the time, the United States was on the gold standard, which meant that notes issued by the Treasury could be redeemed for a fixed amount of gold. The falling gold reserves raised concerns at home and abroad that the United States might be forced to suspend the convertibility of notes, which may have prompted depositors to withdraw bank notes and convert their wealth into gold. The second source of this instability was that economic activity slowed prior to the panic. The recession raised rates of defaults on loans, which weakened banks’ balance sheets. Fearing for the safety of their deposits, men and women began to withdraw funds from banks. Fear spread and withdrawals accelerated, leading to widespread runs on banks.

Uncle Sam points a gun at 'hard times,' 1893 (Library of Congress Prints and Photographs Division, LC-DIG-ppmsca-29097)

In June, bank runs swept through midwestern and western cities such as Chicago and Los Angeles. More than one-hundred banks suspended operations. From mid-July to mid-August, the panic intensified, with 340 banks suspending operations. As these banks came under pressure, they withdrew funds that they kept on deposit in banks in New York City. Those banks soon felt strained. To satisfy withdrawal requests, money center banks began selling assets. During the fire sale, asset prices plummeted, which threatened the solvency of the entire banking system. In early August, New York banks sought to save themselves by slowing the outflow of currency to the rest of the country. The result was that in the interior local banks were unable to meet currency demand, and many failed. Commerce and industry contracted. In many places, individuals, firms, and financial institutions began to use temporary expediencies, such as scrip or clearing-house certificates, to make payments when the banking system failed to function effectively.

In the fall, the banking panic ended. Gold inflows from Europe lowered interest rates. Banks resumed operations. Cash and credit resumed lubricating the wheels of commerce and industry. Nevertheless, the economy remained in recession until the following summer. According to estimates by Andrew Jalil and Charles Hoffman, industrial production fell by 15.3 percent between 1892 and 1894, and unemployment rose to between 17 and 19 percent. 1 After a brief pause, the economy slumped into recession again in late 1895 and did not fully recover until mid-1897.

While the narrative of each panic revolves around unique individuals and firms, the panics had common causes and similar consequences. Panics tended to occur in the fall, when the banking system was under the greatest strain. Farmers needed currency to bring their crops to market, and the holiday season increased demands for currency and credit. Under the National Banking System, the supply of currency could not respond quickly to an increase in demand, so the price of currency rose instead. That price is known as the interest rate. Increasing interest rates lowered the value of banks’ assets, making it more difficult for them to repay depositors and pushing them toward insolvency. At these times, uncertainty about banks’ health and fear that other depositors might withdraw first sometimes triggered panics, when large numbers of depositors simultaneously ran to their banks and withdrew their deposits. A wave of panics could force banks to sell even more assets, further depressing asset prices, further weakening banks’ balance sheets, and further increasing the public’s unease about banks. This dynamic could, in turn, trigger more runs in a chain reaction that threatened the entire financial system.

In 1884 and 1890, the New York Clearing House stopped the chain reaction by pooling the reserves of its member banks and providing credit to institutions beset by runs, effectively acting as “a central bank with reserve power greater than that of any European central bank,” 2 in the words of scholar Elmus Wicker.

A common result of all of these panics was that they severely disrupted industry and commerce, even after they ended. The Panic of 1873 was blamed for setting off the economic depression that lasted from 1873 to 1879. This period was called the Great Depression, until the even greater depression of 1893 received that label, which it held until the even greater contraction in the 1930s -- now known as the Great Depression.

Another common result of these panics was soul searching about ways to reform the financial system. Rumination regarding reform was particularly prolific during the last two decades of the Gilded Age, which coincided with the Progressive Era of American politics. Following the Panic of 1893, for example, the American Bankers Association, secretary of Treasury, and comptroller of currency all proposed reform legislation. Congress held hearings on these proposals but took no action. Over the next fourteen years, politicians, bureaucrats, bankers, and businessmen repeatedly proposed additional reforms (see Wicker, 2005, for a summary), but prior to the Panic of 1907, no substantial reforms occurred.

The adjective “gilded” means covered with a thin gold veneer on the outside but not golden on the inside. In some ways, this definition fits the nineteenth century banking and monetary system. The gold standard and other institutions of that system promised efficiency and stability. The American economy grew rapidly. The United States experienced among the world’s fastest growth rates of income per capita. But, the growth of the nation’s wealth obscured to some extent social and financial problems, such as periodic panics and depressions. At the time, academics, businessmen, policymakers, and politicians debated the benefits and costs of our banking system and how it contributed to national prosperity and instability. Those debates culminated in the Aldrich-Vreeland Act of 1908, which established the National Monetary Commission and tasked it to study these issues and recommend reforms. The commission’s recommendations led to the creation of the Federal Reserve System in 1913.

Endnotes

Andrew Jalil, “A New History of Banking Panics in the United States, 1825-1929: Construction and Implications,” 323.

Charles Hoffman, The Depression of the Nineties, 109. Elmus Wicker, Banking Panics of the Gilded Age, 16.

Bibliography

Calomiris, Charles W., and Gary Gorton. “The Origins of Banking Panics: Models, Facts, and Bank Regulation.” In Financial Markets and Financial Crises, 109-74. ed. R. Glenn Hubbard, Chicago: University of Chicago Press, 1991.

Carlson, Mark, “Causes of Bank Suspensions in the Panic of 1893,” Federal Reserve Board of Governors, 2011. http://www.federalreserve.gov/pubs/feds/2002/200211/200211pap.pdf.

Grossman, Richard S. “The Macroeconomic Consequences of Bank Failures under the National Banking System.” Explorations in Economic History 30, no. 3 (1993): 294-320.

Jalil, Andrew J. “A New History of Banking Panics in the United States, 1825-1929: Construction and Implications.” American Economic Journal: Macroeconomics 7, no. 3 (July 2015): 295-330.

Kemmerer, E. W. “Seasonal Variations in the Relative Demand for Money and Capital in the United States.” National Monetary Commission Doc. 588, 1910. https://fraser.stlouisfed.org/title/633

Sprague, O. M. W. “History of Crises under the National Banking System.” National Monetary Commission Doc. 538, 1910. https://fraser.stlouisfed.org/title/653

Twain, Mark, and Charles Dudley Warner. The Gilded Age: A Tale of Today. Hartford, Conn.: American Publishing Company, 1873. [Online at Project Gutenberg: http://www.gutenberg.org/files/3178/3178-h/3178-h.htm]

Wicker, Elmus. Banking Panics of the Gilded Age. New York: Cambridge University Press, 2000.

Wicker, Elmus. The Great Debate on Banking Reform: Nelson Aldrich and the Origins of the Fed. Columbus, Ohio: Ohio State University Press, 2005.


Federal Deposit Insurance Corporation

Transcript of Speech by President Franklin D. Roosevelt Regarding the Banking Crisis
March 12, 1933

I want to talk for a few minutes with the people of the United States about banking -- with the comparatively few who understand the mechanics of banking but more particularly with the overwhelming majority who use banks for the making of deposits and the drawing of checks. I want to tell you what has been done in the last few days, why it was done, and what the next steps are going to be. I recognize that the many proclamations from State Capitols and from Washington, the legislation, the Treasury regulations, etc., couched for the most part in banking and legal terms should be explained for the benefit of the average citizen. I owe this in particular because of the fortitude and good temper with which everybody has accepted the inconvenience and hardships of the banking holiday. I know that when you understand what we in Washington have been about I shall continue to have your cooperation as fully as I have had your sympathy and help during the past week.

First of all let me state the simple fact that when you deposit money in a bank the bank does not put the money into a safe deposit vault. It invests your money in many different forms of credit-bonds, commercial paper, mortgages and many other kinds of loans. In other words, the bank puts your money to work to keep the wheels of industry and of agriculture turning around. A comparatively small part of the money you put into the bank is kept in currency -- an amount which in normal times is wholly sufficient to cover the cash needs of the average citizen. In other words the total amount of all the currency in the country is only a small fraction of the total deposits in all of the banks.

What, then, happened during the last few days of February and the first few days of March? Because of undermined confidence on the part of the public, there was a general rush by a large portion of our population to turn bank deposits into currency or gold. -- A rush so great that the soundest banks could not get enough currency to meet the demand. The reason for this was that on the spur of the moment it was, of course, impossible to sell perfectly sound assets of a bank and convert them into cash except at panic prices far below their real value.

By the afternoon of March 3 scarcely a bank in the country was open to do business. Proclamations temporarily closing them in whole or in part had been issued by the Governors in almost all the states.

It was then that I issued the proclamation providing for the nation-wide bank holiday, and this was the first step in the Government's reconstruction of our financial and economic fabric.

The second step was the legislation promptly and patriotically passed by the Congress confirming my proclamation and broadening my powers so that it became possible in view of the requirement of time to entend (sic) the holiday and lift the ban of that holiday gradually. This law also gave authority to develop a program of rehabilitation of our banking facilities. I want to tell our citizens in every part of the Nation that the national Congress -- Republicans and Democrats alike -- showed by this action a devotion to public welfare and a realization of the emergency and the necessity for speed that it is difficult to match in our history.

The third stage has been the series of regulations permitting the banks to continue their functions to take care of the distribution of food and household necessities and the payment of payrolls.

This bank holiday while resulting in many cases in great inconvenience is affording us the opportunity to supply the currency necessary to meet the situation. No sound bank is a dollar worse off than it was when it closed its doors last Monday. Neither is any bank which may turn out not to be in a position for immediate opening. The new law allows the twelve Federal Reserve banks to issue additional currency on good assets and thus the banks that reopen will be able to meet every legitimate call. The new currency is being sent out by the Bureau of Engraving and Printing in large volume to every part of the country. It is sound currency because it is backed by actual, good assets.

A question you will ask is this - why are all the banks not to be reopened at the same time? The answer is simple. Your Government does not intend that the history of the past few years shall be repeated. WE do not want and will not have another epidemic of bank failures.

As a result we start tomorrow, Monday, with the opening of banks in the twelve Federal Reserve Bank cities -- those banks which on first examination by the Treasury have already been found to be all right. This will be followed on Tuesday by the resumption of all their functions by banks already found to be sound in cities where there are recognized clearinghouses. That means about 250 cities of the United States.

On Wednesday and succeeding days banks in smaller places all through the country will resume business, subject, of course, to the Government's physical ability to complete its survey. It is necessary that the reopening of banks be extended over a period in order to permit the banks to make applications for necessary loans, to obtain currency needed to meet their requirements and to enable the Government to make common sense checkups.

Let me make it clear to you that if your bank does not open the first day you are by no means justified in believing that it will not open. A bank that opens on one of the subsequent days is in exactly the same status as the bank that opens tomorrow.

I know that many people are worrying about State banks not members of the Federal Reserve System. These banks can and will receive assistance from member banks and from the Reconstruction Finance Corporation. These state banks are following the same course as the national banks except that they get their licenses to resume business from the state authorities, and these authorities have been asked by the Secretary of the Treasury to permit their good banks to open up on the same schedule as the national banks. I am confident that the state banking departments will be as careful as the National Government in the policy relating to the opening of banks and will follow the same broad policy.

It is possible that when the banks resume a very few people who have not recovered from their fear may again begin withdrawals. Let me make it clear that the banks will take care of all needs -- and it is my belief that hoarding during the past week has become an exceedingly unfashionable pastime. It needs no prophet to tell you that when the people find that they can get their money -- that they can get it when they want it for all legitimate purposes -- the phantom of fear will soon be laid. People will again be glad to have their money where it will be safely taken care of and where they can use it conveniently at any time. I can assure you that it is safer to keep your money in a reopened bank than under the mattress.

The success of our whole great national program depends, of course, upon the cooperation of the public -- on its intelligent support and use of a reliable system.

Remember that the essential accomplishment of the new legislation is that it makes it possible for banks more readily to convert their assets into cash than was the case before. More liberal provision has been made for banks to borrow on these assets at the Reserve Banks and more liberal provision has also been made for issuing currency on the security of those good assets. This currency is not fiat currency. It is issued only on adequate security -- and every good bank has an abundance of such security.

One more point before I close. There will be, of course, some banks unable to reopen without being reorganized. The new law allows the Government to assist in making these reorganizations quickly and effectively and even allows the Government to subscribe to at least a part of new capital which may be required.

I hope you can see from this elemental recital of what your government is doing that there is nothing complex, or radical in the process.

We had a bad banking situation. Some of our bankers had shown themselves either incompetent or dishonest in their handling of the people's funds. They had used the money entrusted to them in speculations and unwise loans. This was of course not true in the vast majority of our banks but it was true in enough of them to shock the people for a time into a sense of insecurity and to put them into a frame of mind where they did not differentiate, but seemed to assume that the acts of a comparative few had tainted them all. It was the Government's job to straighten out this situation and do it as quickly as possible -- and the job is being performed.

I do not promise you that every bank will be reopened or that individual losses will not be suffered, but there will be no losses that possibly could be avoided and there would have been more and greater losses had we continued to drift. I can even promise you salvation for some at least of the sorely pressed banks. We shall be engaged not merely in reopening sound banks but in the creation of sound banks through reorganization. It has been wonderful to me to catch the note of confidence from all over the country. I can never be sufficiently grateful to the people for the loyal support they have given me in their acceptance of the judgment that has dictated our course, even though all of our processes may not have seemed clear to them.

After all there is an element in the readjustment of our financial system more important than currency, more important than gold, and that is the confidence of the people. Confidence and courage are the essentials of success in carrying out our plan. You people must have faith you must not be stampeded by rumors or guesses. Let us unite in banishing fear. We have provided the machinery to restore our financial system it is up to you to support and make it work.


The Banking Crisis - History

Banks are susceptible to a range of risks. These include credit risk (loans and others assets turn bad and ceasing to perform), liquidity risk (withdrawals exceed the available funds), and interest rate risk (rising interest rates reduce the value of bonds held by the bank, and force the bank to pay relatively more on its deposits than it receives on its loans).

Banking problems can often be traced to a decrease the value of banks’ assets. An deterioration in asset values can occur, for example, due to a collapse in real estate prices or from an increased number of bankruptcies in the nonfinancial sector. Or, if a government stops paying its obligations, this can trigger a sharp decline in value of bonds held by banks in their portfolios. When asset values decrease substantially, a bank can end up with liabilities that are bigger than its assets (meaning that the bank has negative capital, or is “insolvent”). Or, the bank can still have some capital, but less than a minimum required by regulations (this is sometimes called “technical insolvency”)

Bank problems can also be triggered or deepened if a bank faces too many liabilities coming due and does not have enough cash (or other assets that can be easily turned into cash) to satisfy those liabilities. This can happen, for example, if many depositors want to withdraw deposits at the same time (depositor run on the bank). It can also happen also if the bank’s borrowers want their money bank and the bank does not have enough cash on hand. The bank can become illiquid. It is important to note that illiquidity and insolvency are two different things. For example, a bank can be solvent but illiquid (that is, it can have enough capital but not enough liquidity on its hands). However, many times, insolvency and illiquidity come hand in hand. When there is a major decline in asset values, depositors and other banks borrowers often start feeling uneasy and demand their money bank, deepening the bank’s troubles.

A (systemic) banking crisis occurs when many banks in a country are in serious solvency or liquidity problems at the same time—either because there are all hit by the same outside shock or because failure in one bank or a group of banks spreads to other banks in the system. More specifically, a systemic banking crisis is a situation when a country’s corporate and financial sectors experience a large number of defaults and financial institutions and corporations face great difficulties repaying contracts on time. As a result, non-performing loans increase sharply and all or most of the aggregate banking system capital is exhausted. This situation may be accompanied by depressed asset prices (such as equity and real estate prices) on the heels of run-ups before the crisis, sharp increases in real interest rates, and a slowdown or reversal in capital flows. In some cases, the crisis is triggered by depositor runs on banks, though in most cases it is a general realization that systemically important financial institutions are in distress.

Systemic banking crises can be very damaging. They tend to lead affected economies into deep recessions and sharp current account reversals. Some crises turned out to be contagious, rapidly spreading to other countries with no apparent vulnerabilities. Among the many causes of banking crises have been unsustainable macroeconomic policies (including large current account deficits and unsustainable public debt), excessive credit booms, large capital inflows, and balance sheet fragilities, combined with policy paralysis due to a variety of political and economic constraints. In many banking crises, currency and maturity mismatches were a salient feature, while in others off-balance sheet operations of the banking sector were prominent.
A global database of banking crises was first compiled by Caprio and Klingebiel (1996). The latest version of the database, updated to reflect the recent global financial crisis, is available as Laeven and Valencia (2012). It identifies 147 systemic banking crises (of which 13 are borderline events) from 1970 to 2011. It also reports on 218 currency crises (defined as nominal depreciation of the currency vis-à-vis the U.S. dollar of at least 30 percent that is also at least 10 percentage points higher than the rate of depreciation in the year before) and 66 sovereign debt crises (defined by government defaulting on its debt to private creditors) over the same period. The database has detailed information about the policy responses to resolve crises in different countries. Analyses based on the dataset, such as Cihák and Schaeck (2010) suggest that consistently predicting banking crises is very difficult, but there are some variables (such as those capturing high leverage and rapid credit growth) that indicate increased likelihood of a crisis.

Chapter 2 of the Global Financial Development Report uses the Laeven and Valencia (2012) version of the database of banking crises to analyze what works (and what does not) in banking supervision and regulation. The chapter and the underlying paper (Čihák, Demirgüç-Kunt, Martínez Pería, and Mohseni-Cheraghlou 2012) use the responses from the World Bank’s Banking Regulation and Supervision Survey (accompanying the Global Financial Development Report ) and performs an econometric analysis comparing countries that ended up in banking crises and those that managed to avoid them. The report and the paper find that find that crisis-hit countries had less stringent and more complex definitions of minimum capital, lower actual capital ratios, were less strict in the regulatory treatment of bad loans and loan losses, and faced fewer restrictions on non-bank activities. They had greater disclosure requirements but weaker incentives for the private sector to monitor banks’ risks. Overall, changes in regulation and supervision during the global financial crisis have been only gradual at best. Some changes, such as increasing capital ratios and strengthening resolution regimes, have gone in the right direction (making regulation in crisis countries closer to that in non-crisis countries), but at the same time, private sector incentives to monitor banks’ risks have been weakened by some of the policy interventions during the crisis. The analysis shows scope for strengthening regulation and supervision as well as private sector’s incentives to monitor risk-taking.

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2006. “Bank Concentration, Competition and Crises: First Results.”Journal of Banking & Finance 30: 1581–1603.

Caprio, Gerard, and Daniela Klingebiel, 1996, “Bank Insolvencies: Cross-Country Experience.” Policy Research Working Paper No.1620. World Bank, Washington, DC.

Čihák, Martin and Schaeck, Klaus, 2010. "How well do aggregate prudential ratios identify banking system problems?"Journal of Financial Stability, 6(3), 130–144.

Čihák, Martin, Asli Demirgüç-Kunt, María Soledad Martínez Pería, and Amin Mohseni-Cheraghlou. 2012. “Bank Regulation and Supervision around the World: A Crisis Update”, Policy Research Working Paper 6286, World Bank, Washington, DC.

Demirgüç-Kunt, Asli, and Enrica Detragiache. 1997. “The Determinants of Banking Crises in Developing and Developed Countries.” IMF Staff Papers 45: 81–109.

Kaminsky, Graciela, and Carmen Reinhart. 1999. “The Twin Crises: The Causes of Banking and Balance of Payments Problems.” American Economic Review 89 (3): 473–500.

Laeven, Luc, and Fabian Valencia. 2012. “Systemic Banking Crisis Database: An Update.” Working Paper 08/224, International Monetary Fund, Washington, DC.

Reinhart, Carmen, and Kenneth Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press, Princeton.


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Nobody knew, as the stock market imploded in October 1929, that years of depression lay ahead and that the market would stay seized up for years. In its regular summation of the president’s week after Black Tuesday (Oct. 29), TIME put the market crash in the No. 2 position, after devastating storms in the Great Lakes region. TIME described the stock-swoon this way: “For so many months, so many people had saved money and borrowed money and borrowed on their borrowings to possess themselves of the little pieces of paper by virtue of which they became partners of U.S. Industry. Now they were trying to get rid of them even more frantically than they had tried to get them. Stocks bought without reference to their earnings were being sold without reference to their dividends.” The crisis that began that autumn and led into the Great Depression would not fully resolve for a decade.

Read the Nov. 4, 1929, issue, here in the TIME Vault:Bankers v. Panic

Here&rsquos proof that the every-seven-years formulation hasn&rsquot always held true: The OPEC oil embargo is widely viewed as the first major, discrete event after the Crash of 󈧡 to have deep, wide-ranging economic effects that lasted for years. OPEC, responding to the United States’ involvement in the Yom Kippur War, froze oil production and hiked prices several times beginning on October 16. Oil prices eventually quadrupled, meaning that gas prices soared. The embargo, TIME warned in the days after it started, “could easily lead to cold homes, hospitals and schools, shuttered factories, slower travel, brownouts, consumer rationing, aggravated inflation and even worsened air pollution in the U.S., Europe and Japan.”

Read the 1973 cover story, here in the TIME Vault:The Oil Squeeze

The recession of the early 1980s lasted from July 1981 to November of the following year, and was marked by high interest rates, high unemployment and rising prices. Unlike market-crash-caused crises, it’s impossible to pin this one to a particular date. TIME&rsquos cover story of Feb. 8, 1982, is as good a place as any to take a sounding. Titled simply “Unemployment on the Rise,” the article examined the dire landscape and groped for solutions that would only come with an upturn in the business cycle at the end of the year. “For the first time in years, polls show that more Americans are worried about unemployment than inflation,” TIME reported. A White House source told TIME: “If unemployment breaks 10%, we’re in big trouble.&rdquo Unemployment peaked the following November at 10.8%.

Read the 1982 cover story, here in the TIME Vault:Unemployment: The Biggest Worry

If the meaning of the Crash of 󈧡 was underappreciated at the time it happened, the meaning of Black Monday 1987 was probably overblown&mdashthough understandably, given what happened. The 508-point drop in the Dow Jones Industrial Average on October 19 was, and remains, the biggest one-day percentage loss in the Dow’s history. But the reverberations weren’t all that severe by historical standards. “Almost an entire nation become paralyzed with curiosity and concern,” TIME reported. “Crowds gathered to watch the electronic tickers in brokers’ offices or stare at television monitors through plate-glass windows. In downtown Boston, police ordered a Fidelity Investments branch to turn off its ticker because a throng of nervous investors had spilled out onto Congress Street and was blocking traffic.”

Read the 1987 cover story, here in the TIME Vault:The Crash

The dot-com bubble deflated relatively slowly, and haltingly, over more than two years, but it was nevertheless a discrete, identifiable crash that paved the way for the early-2000s recession. Fueled by speculation in tech and Internet stocks, many of dubious real value, the Nasdaq peaked on March 10, 2000, at 5132. Stocks were volatile for years before and after the peak, and didn’t reach their lows until November of 2002. In an article in the Jan. 8, 2001, issue, TIME reported that market problems had spread throughout the economy. The “distress is no longer confined to young dotcommers who got rich fast and lorded it over the rest of us. And it’s no longer confined to the stock market. The economic uprising that rocked eToys, Priceline.com, Pets.com and all the other www. s has now spread to blue-chip tech companies and Old Economy stalwarts.”

Read the 2001 cover story, here in the TIME Vault:How to Survive the Slump

On Sept. 15, 2008, after rounds of negotiations between Wall Street executives and government officials, Lehman Bros. collapsed into bankruptcy. And so did AIG. Merrill Lynch was forced to sell itself to Bank of America. And that was just the beginning. TIME pulled no punches in its September 29 cover story, titled “How Wall Street Sold Out America” and written by Andy Serwer and Allan Sloan. “If you’re having a little trouble coping with what seems to be the complete unraveling of the world’s financial system, you needn’t feel bad about yourself,” the men wrote. “It’s horribly confusing, not to say terrifying even people like us, with a combined 65 years of writing about business, have never seen anything like what’s going on. They advised readers that “the four most dangerous words in the world for your financial health are ‘This time, it’s different.’ It’s never different. It’s always the same, but with bigger numbers.”

Read the 2008 cover story, here in the TIME Vault: How Wall Street Sold Out America


The History of U.S. Recessions and Banking Crises

I have never been entirely satisfied with how either economists or historians identify and date past U.S. recessions and banking crises. Economists, as their studies go further back in time, have a tendency to rely on highly unreliable data series that exaggerate the number of recessions and panics, something most strikingly but not exclusively documented in the notable work of Christina Romer (1986b, 1989, 2009). Historians, on the other hand, relying on more anecdotal and less quantitative evidence, tend to exaggerate the duration and severity of recessions. So I have created a revised chronology in the table below. From the nineteenth century to the present, it distinguishes between three types of events: major recessions, bank panics, and periods of bank failures. I have tried to integrate the best of the approaches of both economists and historians, using them to cross check each other. My chronology therefore differs in important ways from prior lists.

One of the table’s benefits is that it gives a visual presentation of which recessions were accompanied by bank panics and which were not. Equally important, it distinguishes between bank panics and periods of significant numbers of bank failures. These two categories are often confused or conflated, and yet this distinction is critical. Not all bank panics (periods of contagious runs and sometimes bank suspensions) were accompanied by numerous bank failures, nor were all periods of numerous failures accompanied by panics.

Among other advantages, the table helps highlight how sui generis the Great Depression was. Not only does it have the longest downturn (43 months), but it also is one of the few depressions accompanied by both bank panics and numerous bank failures. Once the Great Depression is thrown out as a statistical outlier, we observe no significant change in the frequency, duration, or magnitude of recessions between the period before and the period after that unique downturn. Given that the Great Depression witnessed the initiation of extensive government policies to alleviate depressions and that the Federal Reserve had been created fifteen years earlier explicitly to prevent such crises, this overall historical continuity with a single exception indicates that government intervention and central banking has done little, if anything, to dampen the business cycle.

There has been a dramatic elimination of bank panics, at least until the financial crisis of 2007-2008, but the timing suggests that deposit insurance more than the Federal Reserve deserves the credit. Furthermore, note that more outbreaks of numerous bank failures occurred in the hundred years after the Federal Reserve was created than the hundred years before, with the Federal Reserve presiding over the most serious case of all: the Great Depression.

Because my table departs from previous lists and dating, in what follows, I explain the most important differences for each of the three categories. At the end of the post is a list of the most useful references I consulted.

Recessions

I have almost entirely confined the list of major recessions to those constituting part of a standard business cycle, omitting periods of economic dislocation resulting from U.S. wars or government embargoes. For the number and dating of recessions from 1948 forward, I have exclusively followed the National Bureau of Economic Research (NBER). But prior to 1929, the NBER notoriously exaggerates the volatility of the U.S. economy. Moreover, between 1929 and 1948, the NBER reports a post-World War II recession lasting from February to October 1945 that no one was aware of at time, as easily confirmed by looking at the unemployment data as well as contemporary writings. Richard K. Vedder and Lowell E. Gallaway (1993) pointed out in their neglected study of U.S. unemployment that this alleged postwar recession is a statistical artifact that varies in severity with the regular comprehensive revisions of GNP/GDP estimates by the Bureau of Economic Analysis (BEA). The BEA’s original estimates showed only a minor downturn, subsequent revisions converted it into a major downturn, and the latest comprehensive revision of 2013 have reduced its magnitude, although not to the level of the BEA’s original estimates.

For the pre-1929 period, therefore, I have only listed recessions that can be documented with unemployment data or more traditional historical evidence. The unemployment data I have employed are the revisions of both J. R. Vernon (1994) and Romer (1986b). I have still accepted NBER dating, which only goes back to 1857, for those pre-1929 recessions that I consider genuine, with the notable exception of 1873. In that case, the NBER dating (based on the Kuznets-Kendrick series) of a 65-month recession is so inconsistent with other evidence that it was even questioned by Milton Friedman and Anna Jacobson Schwartz in their Monetary History (1963). This is one of the most striking cases in which some observers at the time and many economists today have confused mild secular deflation with a depression – a confusion exposed by George Selgin in Less than Zero (1997). Even the Kuznets-Kendrick estimates show no decline in real net national product during this recession, and an acceleration of its growth after 1875. I have therefore accepted Joseph H. Davis’s (2006) revised dating, shortening this recession to not more than 27 months, and probably less if he had attempted a monthly rather than just an annual revision of the depression’s end point.

Estimates of U.S. GDP prior to the Civil War are even more problematic, making precise monthly dating of recessions impossible. So I have relied upon the consensus of standard historical accounts along with the GDP statistics in Historical Statistics: Millennial Edition (Carter 2006) to determine what qualifies as an actual recession and its annual dating. The one case where I diverge from some (but not all) mainstream historical accounts is the alleged recession during the banking crisis that began in 1839, after the recovery from the 1837 recession. As Friedman and Schwartz (1963), Douglass C. North (1961), and Peter Temin (1969) have all noted, estimates of real GDP growth over the next four years are quite robust. Thus, 1839-1843 appears to be another case were deflation (in this case, quite severe) is confused with depression.

Bank Panics

The number of bank panics is also often exaggerated. For the post-Civil War period, many authors follow the enumeration first compiled by O. M. W. Sprague (1910), and some even add in a few more. But Elmus Wicker (2000) has persuasively demonstrated that the alleged Panics of 1884 and 1890 were really only incipient financial crises nipped in the bud by the actions of bank clearinghouses. For the pre-Civil War period, especially egregious in its listing of panics is the widely cited work of Willard Long Thorp (1926), which even mistakenly attributes to the United Sates panics that affected only England (those in 1825 and 1847).

I have confined my own list to those panics that Andrew J. Jalil (2015) in his comprehensive survey of previous literature defines as “major,” with two exceptions. First, I have omitted the very minor economic contraction of 1833, following Andrew Jackson’s phased withdrawal of government deposits from the Second Bank of the United States, since the impact on banks was almost entirely confined to the Second Bank and its branches. Second, I have included the more pronounced global financial crisis at the outbreak of World War I, in which the U.S. stock market was shut down for four months, although the emergency currency authorized under the Aldrich-Vreeland Act prevented bank suspensions. The monthly dating of other panics listed is confined to the period during which major suspensions or runs occurred and does not always reflect how long banks suspended, which for the War of 1812 was until January 1817.

Bank Failures

Bank panics, even when accompanied by numerous suspensions (or what Friedman and Schwartz prefer to call “restrictions on cash payments” to distinguish them from government suspensions of redeemability), do not always result in a major number of bank failures.

For instance, Calomiris and Gorton report the failure of only six national banks out of a total of 6412 during the Panic of 1907, or less than 0.1 percent. Of course the Panic of 1907 was concentrated among state banks and trust companies. Unfortunately, as far as I can tell, there are no good time series on the failures of state banks for the period prior to the creation of the Federal Reserve. Yet there were over 12,000 state banks at the outset of the Panic of 1907. One very fragmentary and incomplete estimate of total bank suspensions (rather than failures) in Historical Statistics (1975), including both state and national banks, puts the number during that panic at 153. Even if all suspensions had resulted in failures, which of course did not happen, we still have a failure rate of 0.7 percent for all commercial banks.

Confusion of bank suspensions with bank failures can even infect serious scholarly work. For example, in Michael D. Bordo and David C. Wheelock (1998), charts meant to show bank failures are instead clearly depicting statistics on the annual number of bank suspensions. Similarly, periods of numerous bank failures do not always coincide with bank panics, as the S&L crisis dramatically illustrates. So it is crucial to distinguish between periods of panics and failures, although specifying the latter requires judgment calls. For the monthly number of national bank failures prior to the Fed’s creation, I have depended heavily on Comptroller of the Currency (1915), v. 2, Table 35, pp. 66-103.

Summary

To be sure, banking in the United States has never been fully deregulated. Even from 1846 until 1861, under the Independent Treasury during the alleged free-banking period, when there was almost no significant national regulation of the financial system, state governments still imposed extensive, counter-productive banking regulation. This fact obviously complicates any comparison of the periods before and after the creation of the Federal Reserve System in 1914. Nonetheless, such a comparison offers more than a prima facie case against the Fed’s success at either stabilizing the U.S. economy or preventing banking crises. In short, the widespread belief among economists, historians, and journalists that the Federal Reserve was an essential, major improvement appears to be no more than unreflective faith in government economic management, with little foundation in the historical evidence.

Acknowledgments: I would like to thank Graham Newell and Kurt Schuler for their invaluable assistance and comments while preparing this table. Any remaining errors or oversights are my responsibility.

References

Michael D. Bordo, “Financial Crises, Banking Crises, Stock Market Crashes and the Money Supply: Some International Evidence, 1870-1933,” in Financial Crises and the World Banking System, ed. by Forrest Capie and Geoffrey E. Wood (New York: St. Martin’s Press, 1986).

Michael D. Bordo and Joseph G. Haubrich, “Credit Crises, Money and Contractions,” NBER Working Paper Series, No. 15389 (September 2009).

Michael D. Bordo and David C. Wheelock, “Price Stability and Financial Stability: The Historical Record,” Federal Reserve Bank of St. Louis Review, 80 (September-October 1998): 41-62.

Charles W. Calomiris and Gary Gorton, “The Origins of Banking Panics: Models, Facts, and Bank Deregulation,” in Financial Markets and Financial Crises, ed. by R. Glenn Hubbard (Chicago: University of Chicago Press, 1991).

Comptroller of the Currency, Annual Report, December 7, 1914, v. 2 (Washington: Government Printing Office, 1915).

Milton Friedman and Anna Jacobson Schwartz, Monetary History of the United States, 1867-1969 (Princeton, NJ: Princeton University Press, 1963).

David Glasner, ed., Business Cycles and Depressions: An Encyclopedia (New York: Garland, 1997).

Gary Gorton, “Bank Panics and Business Cycles,” Oxford Economic Papers, 40 (December 1988), pp. 751-81.

Jeffrey Rogers Hummel, “The Upside of Government Default,” The American (February 16, 2012).

Andrew J. Jalil, "A New History of Banking Panics in the United States, 1825-1929: Construction and Implications," American Economic Journal: Macroeconomics, 7 (July 2015): 295-330, plus an online “Dataset”.

Geoffrey H. Moore and Victor Zarnowitz, “The Development and Role of the National Bureau of Economic Research’s Business Cycle Chronologies,” in The American Business Cycle: Continuity and Change, ed. by Robert J. Gordon (Chicago: University of Chicago Press, 1986).

Douglass C. North, The Economic Growth of the United States, 1790–1860 (New York: Prentice Hall, 1961).

Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press, 2009).

Christina Romer, “Spurious Volatility in Historical Unemployment Data," Journal of Political Economy 94 (February 1986a): 1-37.

Anna J. Schwartz, “Real and Pseudo-Financial Crises,” in Financial Crises and the World Banking System, ed. by Forrest Capie and Geoffrey E. Wood (New York: St. Martin’s Press, 1986).

George Selgin, William D. Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure,” Journal of Macroeconomics, 34 (September 2012): 569–596.

M. W. Sprague, History of Crises Under the National Banking System (Washington: Government Printing Office, 1910).

Peter Temin, The Jacksonian Economy (New York: W.W. Norton, 1969).

Willard Long Thorp, Business Annals . . . (New York: National Bureau of Economic Research, 1926).

Van Fenstermaker, The Development of American Commercial Banking: 1782-1837 (Kent, OH: Kent State University, 1965).

Elmus Wicker, Banking Panics of the Gilded Age (Cambridge: Cambridge University Press, 2000).


The Aftermath

The Wall Street bailout package was approved in the first week of October 2008.  

The package included many measures, such as a huge government purchase of "toxic assets," an enormous investment in bank stock shares, and financial lifelines to Fannie Mae and Freddie Mac.

$440 Billion

The amount spent by the government through the Troubled Asset Relief Program (TARP). It got back $442.6 billion after assets bought in the crisis were resold at a profit.

The public indignation was widespread. It appeared that bankers were being rewarded for recklessly tanking the economy. But it got the economy moving again. It also should be noted that the investments in the banks were fully recouped by the government, with interest.

The passage of the bailout package stabilized the stock markets, which hit bottom in March 2009 and then embarked on the longest bull market in its history.

Still, the economic damage and human suffering were immense. Unemployment reached 10%. About 3.8 million Americans lost their homes to foreclosures.  

About Dodd-Frank

The most ambitious and controversial attempt to prevent such an event from happening again was the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. On the financial side, the act restricted some of the riskier activities of the biggest banks, increased government oversight of their activities, and forced them to maintain larger cash reserves. On the consumer side, it attempted to reduce predatory lending.

By 2018, some portions of the act had been rolled back by the Trump Administration, although an attempt at a more wholesale dismantling of the new regulations failed in the U.S. Senate.

Those regulations are intended to prevent a crisis similar to the 2007-2008 event from happening again.

Which doesn't mean that there won't be another financial crisis in the future. Bubbles have occurred periodically at least since the 1630s Dutch Tulip Bubble.


Financial Banking Crisis 2008 - Detailed Overview

The 2008 financial crisis was the largest and most severe financial event since the Great Depression and reshaped the world of finance and investment banking. The effects are still being felt today, yet many people do not actually understand the causes or what took place. Below is a brief summary of the causes and events that redefined the industry and the world in 2007 and 2008.

2008 Financial Crisis - The History

The underlying cause of the financial crisis was a combination of debt and mortgage-backed assets. Since the end of WW2, house prices in the United States have been steadily rising. There have been a few fluctuations but the trend has been upward.

In the 1980s financial institutions and traders realized that US mortgages were a previously untapped asset. Traders at Salomon Brothers and Drexel Burnham Lambert were looking to expand the bond market and they discovered that the steady stream of payments from US mortgages could be restructured into bonds and then sold off to investors. Prior to this, investors had no access to the US mortgage market other than by buying real estate or investing in construction companies, which was suboptimal and did not necessarily give the correct exposure to house prices.

2008 Economic Crisis - The Causes

In the late 1990s and early 2000s, there was an explosion in the issuance of bonds backed by mortgages, also known as mortgage-backed securities (MBSs). The reason for this was the use of securitization. In brief, securitization is the pooling of debt and then issuing assets based upon that debt.

Investment banks were buying mortgages from mortgage issuers, repackaging them and then selling off specific tranches of the debt to investors. As time went on, there were fewer and fewer new mortgages to securitize so the structured products groups at banks started repacking MBS 's (i.e. taking the unsellable tranches of lots of MBS 's, repackaging them and then selling the new product – called collateralized debt obligations or CDOs).

Theoretically, the pooling of different mortgages reduced risk and therefore these assets were quite safe, but in reality, the majority of the mortgages being securitized were of poor quality (also called sub-prime). The rating agencies who rated the MBSs and CDOs did not fully appreciate the low-quality mortgages backing the assets they were rating, or they overestimated the benefits of diversification in the housing market and as a result, many of the MBSs and CDOs were rated AAA (the very top rating).

The top senior tranche of the MBSs and CDOs were rated AAA and paid a low rate of interest whilst the bottom tranches were often rated as junk but paid a very high rate of interest. Many investors did not want the expensive senior tranches which gave a low return and in order to keep the securitization and CDO machine rolling, many investment banks took to keeping these tranches on their own balance sheet.

From the viewpoint of the banks, it was a fantastic move. These assets were AAA rated (i.e. as safe as US treasury bonds at the time), required little capital to borrow against and essentially provided them with a free return. Even though the return on the senior tranches was low, the interest rate in the money markets was even lower so the banks were making an easy spread (borrowing short term in the money markets to buy long-term AAA tranches of CDOs and MBSs) as well as taking the fees for creating the CDOs.

The US and global banks went on a massive spending spree, borrowing vast amounts of money at low rates in the short term to fund their investments. Investment banks had leverage ratios (debt to equity ratio) of 30x or even higher. Some of the top investment banks such as Morgan Stanley, Lehman Brothers, Merrill Lynch, and Bear Stearns were almost entirely funded by short-term borrowing.

Global Financial Housing Crisis - The Run Up at the Banks

In the mid-2000s there were hundreds of billions of dollars worth of mortgages given to individuals with poor credit ratings on adjustable rates. These mortgages typically required low-interest payments (sub 8%) for the first 2 years, then increased to 15% per year for the next 28. There was no way that these sub-prime borrowers would be able to afford the higher repayment rates. As house prices stopped rising and started to fall, homeowners could no longer refinance and remortgage their houses for cash and started to default.

The peak years for issuing these mortgages was in 2005/2006, so by 2007/2008 the default rates on the subprime mortgages suddenly spiked. This meant that some of the bottom tranches on the CDOs and MBSs were being wiped out. Suddenly, investors started to lose confidence in the top AAA tranches and in the banks which held large amounts of them or had exposure to such assets.

The first signs of the crisis were in June 2007 when the 5th largest investment bank in the US, Bear Stearns, announced large losses in two of its hedge funds with exposure to subprime assets. Clients were prevented from withdrawing money and the funds were eventually shut down at a $3 billion dollar loss.

Problems with short-term debt funding and mortgages were not restricted to the United States. In September 2007 the UK mortgage lender and bank Northern Rock was declared insolvent and had to be bought by the UK government. The problem was that Northern Rock had a very small deposit base and was almost entirely funded through the short-term repo markets. After the events at Bear Stearns, the credit markets started to dry up and Northern Rock could not meet its obligations and had to be bailed out.

In October 2007 two of the largest banks in the world, both lost their CEOs. Stan O'Neal of Merrill Lynch and Charles Prince of Citigroup both resigned due to losses on their exposure to subprime debt. They were replaced by John Thain and Vikram Pandit respectively.

Over the next couple of months, there was general unease about the global mortgage and credit markets with many banks and mortgage institutions announcing losses on their subprime exposure. It was in March 2008, however, that things really started to get bad.

Bear Stearns Failure - Toxic Assets

Bear Stearns had a bad run and lost a lot more money following its losses on the mortgage hedge funds it essentially ran out of money in March. JP Morgan had to buy out Bear Stearns with the US government guaranteeing up to $30 billion worth of the most toxic assets owned by Bear. The company was originally agreed to be sold for $2 a share but eventually went through at $10 a share still valuing the company at less than the market price of its head office in New York.

Lehman Brothers Bankruptcy

Bear Stearns was the 5th largest investment bank in the US and after it failed, the 4th biggest bank (Lehman Brothers) was under intense pressure. Over the summer of 2008, the share price of Lehman went on a rollercoaster ride, often gaining or losing 40% or more in a single trading day. All the while, Lehman was hemorrhaging money and needed capital desperately. There was a lot of communication between bank CEO's, Henry Paulson (US Treasury Secretary) and the Federal Reserve in order to try and prevent a crisis.

Lehman tried many different things a capital raise of $4 billion, a deal with Morgan Stanley, a deal with Bank of America, a merger with Barclays but none of it worked. Everything came to a head in September 2008. Lehman Brothers were intending to do a deal with Bank of America for the entire company, but the US government refused to provide any kind of support following the public outcry after the Bear Stearns bailout.

All the banks were suffering at this point but the worst affected after Lehman was the 3rd biggest bank, Merrill Lynch. Although Merrill was not widely publicized in the media as being in trouble, it too was losing money and if Lehman failed, Merrill would be next. During September 2008 the US Treasury orchestrated meetings between all the CEOs of the large banks at the Federal Reserve in order to try and save Lehman Brothers. During these meetings, the government reiterated its position of not providing any form of assistance and insisting that there had to be a market solution similar to that of Long Term Capital Management in the 1990s.

The two banks interested in Lehman at this point were Bank of America and Barclays, with Bank of America being preferred. Barclays, despite not being the preferred bank, was definitely interested in the deal and was about to buy the bank when the UK government and regulators blocked the deal on the grounds that it would make the UK bank less stable.

Bank of America Buys Merrill Lynch

After performing due diligence of Lehman Brothers, none of the other banks were interested without government support except for Bank of America. However, John Thain of Merrill Lynch jumped the gun and on September 14th, 2011, Merrill Lynch was sold to Bank of America for a 70% premium over the previous days trading price.

Lehman Brothers were now out of options and the US government was still refusing to bail them out or to provide any kind of funding for a deal. On Monday 15th September 2008 Lehman Brothers filed for chapter 11 bankruptcy.

Banking Crisis - The Fallout with CDS

All throughout the summer and autumn of 2008 financial institutions had been under immense pressure and the next domino to fall was the insurance giant AIG. Although it was not an investment bank, AIG had a group called AIG Financial Products which had been participating the in the traditional stomping ground of investment banks by issuing derivatives called Credit Default Swaps (CDSs).

Credit Default Swaps are a kind of insurance on bonds. For more information on them, please read the following page.

AIG had been issuing tens of billions of dollars worth of CDSs on mortgage-backed securities and CDOs and because of the turmoil in the financial markets, it was facing the possibility of needing well over $40 billion in cash within a matter of days. AIG had been working closely with JPMorgan to attempt to fill the hole via a capital raise, government loans using some of its insurance assets as collateral and more but none of it was working.

2008 AIG Bailout from the FED

Following the bankruptcy of Lehman Brothers, AIG's credit rating was downgraded on September 16th, which meant it had to post tens of billions of dollars worth of extra collateral to its creditors. The US government and Federal Reserve deemed that AIG had too much counterparty exposure and was too entwined in the global financing system and was 'too big to fail' and less than 48 hours after letting Lehman Brothers fail, they bought equity stakes in AIG for over $80 billion, effectively bailing them out.

Now that two large investment banks and the largest insurance firm in the world had either collapsed, been taken over or bailed out in the space of 3 days the financial markets entered a meltdown. The Dow Jones Industrial Average fell by nearly 30% in the next 2-3 weeks.

Many other financial firms were now facing imminent bankruptcy including Morgan Stanley, Goldman Sachs, Citigroup, Wachovia, and more. Many different combinations of deals and mergers were suggested, but the crisis advanced. Morgan Stanley eventually sold a 21% equity stake to Mitsubishi UFJ for $9 billion, which was paid as the largest check ever written.

TARP - Troubled Asset Relief Program - $700 Billion

Throughout September 2008, the US government and Federal Reserve had been searching for a way to stabilize the financial markets. The plan they devised was to buy troubled assets from the banks in order to reduce uncertainty in the markets. This plan was called the Troubled Asset Relief Program (TARP). TARP was tweaked slightly in October to allow the TARP program to buy equity stakes in the banks as well as buying the assets.

The US government had to ask Congress for $700 billion and was signed into law on October 3rd, 2008. Many of the firms which took money from the TARP program have paid it back. For many this took years and it wasn't until the summer of 2011 the financial markets stabilized and really started growing again.

2008 Financial Credit Crisis Explained

Recommended Reading

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The Great Recession and its Aftermath

The 2007-09 economic crisis was deep and protracted enough to become known as "the Great Recession" and was followed by what was, by some measures, a long but unusually slow recovery.

The period known as the Great Moderation came to an end when the decade-long expansion in US housing market activity peaked in 2006 and residential construction began declining. In 2007, losses on mortgage-related financial assets began to cause strains in global financial markets, and in December 2007 the US economy entered a recession. That year several large financial firms experienced financial distress, and many financial markets experienced significant turbulence. In response, the Federal Reserve provided liquidity and support through a range of programs motivated by a desire to improve the functioning of financial markets and institutions, and thereby limit the harm to the US economy. 1 Nonetheless, in the fall of 2008, the economic contraction worsened, ultimately becoming deep enough and protracted enough to acquire the label “the Great Recession." While the US economy bottomed out in the middle of 2009, the recovery in the years immediately following was by some measures unusually slow. The Federal Reserve has provided unprecedented monetary accommodation in response to the severity of the contraction and the gradual pace of the ensuing recovery. In addition, the financial crisis led to a range of major reforms in banking and financial regulation, congressional legislation that significantly affected the Federal Reserve.

Rise and Fall of the Housing Market

The recession and crisis followed an extended period of expansion in US housing construction, home prices, and housing credit. This expansion began in the 1990s and continued unabated through the 2001 recession, accelerating in the mid-2000s. Average home prices in the United States more than doubled between 1998 and 2006, the sharpest increase recorded in US history, and even larger gains were recorded in some regions. Home ownership in this period rose from 64 percent in 1994 to 69 percent in 2005, and residential investment grew from about 4.5 percent of US gross domestic product to about 6.5 percent over the same period. Roughly 40 percent of net private sector job creation between 2001 and 2005 was accounted for by employment in housing-related sectors.

The expansion in the housing sector was accompanied by an expansion in home mortgage borrowing by US households. Mortgage debt of US households rose from 61 percent of GDP in 1998 to 97 percent in 2006. A number of factors appear to have contributed to the growth in home mortgage debt. In the period after the 2001 recession, the Federal Open Market Committee (FOMC) maintained a low federal funds rate, and some observers have suggested that by keeping interest rates low for a “prolonged period” and by only increasing them at a “measured pace” after 2004, the Federal Reserve contributed to the expansion in housing market activity (Taylor 2007). However, other analysts have suggested that such factors can only account for a small portion of the increase in housing activity (Bernanke 2010). Moreover, the historically low level of interest rates may have been due, in part, to large accumulations of savings in some emerging market economies, which acted to depress interest rates globally (Bernanke 2005). Others point to the growth of the market for mortgage-backed securities as contributing to the increase in borrowing. Historically, it was difficult for borrowers to obtain mortgages if they were perceived as a poor credit risk, perhaps because of a below-average credit history or the inability to provide a large down payment. But during the early and mid-2000s, high-risk, or “subprime,” mortgages were offered by lenders who repackaged these loans into securities. The result was a large expansion in access to housing credit, helping to fuel the subsequent increase in demand that bid up home prices nationwide.

Effects on the Financial Sector

After home prices peaked in the beginning of 2007, according to the Federal Housing Finance Agency House Price Index, the extent to which prices might eventually fall became a significant question for the pricing of mortgage-related securities because large declines in home prices were viewed as likely to lead to an increase in mortgage defaults and higher losses to holders of such securities. Large, nationwide declines in home prices had been relatively rare in the US historical data, but the run-up in home prices also had been unprecedented in its scale and scope. Ultimately, home prices fell by over a fifth on average across the nation from the first quarter of 2007 to the second quarter of 2011. This decline in home prices helped to spark the financial crisis of 2007-08, as financial market participants faced considerable uncertainty about the incidence of losses on mortgage-related assets. In August 2007, pressures emerged in certain financial markets, particularly the market for asset-backed commercial paper, as money market investors became wary of exposures to subprime mortgages (Covitz, Liang, and Suarez 2009). In the spring of 2008, the investment bank Bear Stearns was acquired by JPMorgan Chase with the assistance of the Federal Reserve. In September, Lehman Brothers filed for bankruptcy, and the next day the Federal Reserve provided support to AIG, a large insurance and financial services company. Citigroup and Bank of America sought support from the Federal Reserve, the Treasury, and the Federal Deposit Insurance Corporation.

The Fed’s support to specific financial institutions was not the only expansion of central bank credit in response to the crisis. The Fed also introduced a number of new lending programs that provided liquidity to support a range of financial institutions and markets. These included a credit facility for “primary dealers,” the broker-dealers that serve as counterparties for the Fed’s open market operations, as well as lending programs designed to provide liquidity to money market mutual funds and the commercial paper market. Also introduced, in cooperation with the US Department of the Treasury, was the Term Asset-Backed Securities Loan Facility (TALF), which was designed to ease credit conditions for households and businesses by extending credit to US holders of high-quality asset-backed securities.

Initially, the expansion of Federal Reserve credit was financed by reducing the Federal Reserve’s holdings of Treasury securities, in order to avoid an increase in bank reserves that would drive the federal funds rate below its target as banks sought to lend out their excess reserves. But in October 2008, the Federal Reserve gained the authority to pay banks interest on their excess reserves. This gave banks an incentive to hold onto their reserves rather than lending them out, thus mitigating the need for the Federal Reserve to offset its expanded lending with reductions in other assets. 2

Effects on the Broader Economy

The housing sector led not only the financial crisis, but also the downturn in broader economic activity. Residential investment peaked in 2006, as did employment in residential construction. The overall economy peaked in December 2007, the month the National Bureau of Economic Research recognizes as the beginning of the recession. The decline in overall economic activity was modest at first, but it steepened sharply in the fall of 2008 as stresses in financial markets reached their climax. From peak to trough, US gross domestic product fell by 4.3 percent, making this the deepest recession since World War II. It was also the longest, lasting eighteen months. The unemployment rate more than doubled, from less than 5 percent to 10 percent.

In response to weakening economic conditions, the FOMC lowered its target for the federal funds rate from 4.5 percent at the end of 2007 to 2 percent at the beginning of September 2008. As the financial crisis and the economic contraction intensified in the fall of 2008, the FOMC accelerated its interest rate cuts, taking the rate to its effective floor – a target range of 0 to 25 basis points – by the end of the year. In November 2008, the Federal Reserve also initiated the first in a series of large-scale asset purchase (LSAP) programs, buying mortgage-backed securities and longer-term Treasury securities. These purchases were intended to put downward pressure on long-term interest rates and improve financial conditions more broadly, thereby supporting economic activity (Bernanke 2012).

The recession ended in June 2009, but economic weakness persisted. Economic growth was only moderate – averaging about 2 percent in the first four years of the recovery – and the unemployment rate, particularly the rate of long-term unemployment, remained at historically elevated levels. In the face of this prolonged weakness, the Federal Reserve maintained an exceptionally low level for the federal funds rate target and sought new ways to provide additional monetary accommodation. These included additional LSAP programs, known more popularly as quantitative easing, or QE. The FOMC also began communicating its intentions for future policy settings more explicitly in its public statements, particularly the circumstances under which exceptionally low interest rates were likely to be appropriate. For example, in December 2012, the committee stated that it anticipates that exceptionally low interest rates would likely remain appropriate at least as long as the unemployment rate was above a threshold value of 6.5 percent and inflation was expected to be no more than a half percentage point above the committee’s 2 percent longer-run goal. This strategy, known as “forward guidance,” was intended to convince the public that rates would stay low at least until certain economic conditions were met, thereby putting downward pressure on longer-term interest rates.

Effects on Financial Regulation

When the financial market turmoil had subsided, attention naturally turned to reforms to the financial sector and its supervision and regulation, motivated by a desire to avoid similar events in the future. A number of measures have been proposed or put in place to reduce the risk of financial distress. For traditional banks, there are significant increases in the amount of required capital overall, with larger increases for so-called “systemically important” institutions (Bank for International Settlements 2011a 2011b). Liquidity standards will for the first time formally limit the amount of banks’ maturity transformation (Bank for International Settlements 2013). Regular stress testing will help both banks and regulators understand risks and will force banks to use earnings to build capital instead of paying dividends as conditions deteriorate (Board of Governors 2011).

The Dodd-Frank Act of 2010 also created new provisions for the treatment of large financial institutions. For example, the Financial Stability Oversight Council has the authority to designate nontraditional credit intermediaries “Systemically Important Financial Institutions” (SIFIs), which subjects them to the oversight of the Federal Reserve. The act also created the Orderly Liquidation Authority (OLA), which allows the Federal Deposit Insurance Corporation to wind down certain institutions when the firm’s failure is expected to pose a great risk to the financial system. Another provision of the act requires large financial institutions to create “living wills,” which are detailed plans laying out how the institution could be resolved under US bankruptcy code without jeopardizing the rest of the financial system or requiring government support.

Like the Great Depression of the 1930s and the Great Inflation of the 1970s, the financial crisis of 2008 and the ensuing recession are vital areas of study for economists and policymakers. While it may be many years before the causes and consequences of these events are fully understood, the effort to untangle them is an important opportunity for the Federal Reserve and other agencies to learn lessons that can inform future policy.

Endnotes

Many of these actions were taken under Section 13(3) of the Federal Reserve Act, which at that time authorized lending to individuals, partnerships, and corporations in “unusual and exigent” circumstances and subject to other restrictions. After the amendments to Section 13(3) made by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Federal Reserve lending under Section 13(3) is permitted only to participants in a program or facility with “broad based eligibility,” with prior approval of the secretary of the treasury, and when several other conditions are met.

For more on interest on reserves, see Ennis and Wolman (2010).

Bibliography

Bernanke, Ben, “The Global Saving Glut and the U.S. Current Account Deficit,” Speech given at the Sandridge Lecture, Virginia Association of Economists, Richmond, Va., March 10, 2005.

Bernanke, Ben,“Monetary Policy and the Housing Bubble,” Speech given at the Annual Meeting of the American Economic Association, Atlanta, Ga., January 3, 2010.

Bernanke, Ben, “Monetary Policy Since the Onset of the Crisis,” Speech given at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyo., August 31, 2012.

Covitz, Daniel, Nellie Liang, and Gustavo Suarez. “The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market.” Journal of Finance 68, no. 3 (2013): 815-48.

Ennis, Huberto, and Alexander Wolman. “Excess Reserves and the New Challenges for Monetary Policy.” Federal Reserve Bank of Richmond Economic Brief no. 10-03 (March 2010).

Federal Reserve System, Capital Plan, 76 Fed Reg. 74631 (December 1, 2011) (codified at 12 CFR 225.8).

Taylor, John,“Housing and Monetary Policy,” NBER Working Paper 13682, National Bureau of Economic Research, Cambridge, MA, December 2007.


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