ByStephen D. Simpson, CFA
It is not altogether unreasonable to say that the history of banking in the United States is a history of panics and crises. Most history books cite at least ten distinct bank panics in the 1800s alone, and bank crises in 1907, 1929, and 2007-2009 had significant impacts on the U.S. economy.
In many respects, most banking crises are quite similar. Banks make increasingly risky lending decisions during economic expansions and fail to rein in their activities before a turn in the economy. Eventually businesses struggle during the downturn, fail to repay their loans, a few banks collapse and then depositors run to get their money out before their bank collapses. With the sudden outflow of money, banks curtain their lending activity, the business cycle continues to worsen, more loans go bad and more banks go bust.
The Great Depression was quite possibly the greatest of all bank crises. Economists and historians still argue about the root causes of the Depression, but certain facts are widely accepted by all camps. There was a large expansion in bank lending in the 1920s, declining credit standards and a credit-fueled boom in asset prices. When the economy began to slow, assets could no longer support the debt, leading those assets to be sold quickly and at distressed prices. Those distressed prices caused further problems for borrowers who, in turn, had to sell their assets at distressed prices.
Ultimately, banks found their borrowers unable to repay and the loan collateral worth far less than the loan amounts on the book. Banks pulled back on lending, cutting companies' access to capital, and nervous depositors rushed to get their money out of the banks. Stuck between plunging collateral values, rampant loan defaults and deposit flight, many banks failed entirely, which in turn, cut credit availability even further and triggered still more panic.
The Great Depression made a lasting impact on U.S. policy towards banks. New attitudes emerged with respect to the gold standard and proper monetary policy. Likewise, a host of new banking regulations went into effect: rules that separated commercial and investment banks, (a rule later repealed in the 1990s), rules concerning capital adequacy, risk weighting and reserve requirements, and new programs like the FDIC and its deposit insurance. (To learn more, see What Caused The Great Depression?)
If there is a constant theme throughout bank panics, it is in how banks lower their lending standards and underwrite asset bubbles while regulators take a passive stance. The Great Depression was arguably fueled by excessive lending for stock market speculation. The S&L crisis of the 1980s seems to have stemmed in part from a lessened regulatory burden and excessive lending to real estate developers. The U.S. housing crisis of the 2000s was underpinned by overly aggressive home lending.
The U.S. is in no way unique in its history of bank crises and panics. The very nature of banking, a huge amount of lending underpinned by a thin sliver of equity, means that any large mistakes will have very large impacts, and every country with a banking system has a history of panics and crises.
Japan faced a lending bubble fueled by soaring real estate values and complicated by long-standing ties between banks, major corporations and the government. Banks were discouraged from "embarrassing" corporations by foreclosing on bad loans, and could not adequately clear their balance sheets and recapitalize. Crippled by loans carried on the books for far more than the underlying property was worth, the Japanese banking sector underwent two decades of stagnation and the Japanese economy largely followed. (To learn more, see Lessons Learned: Comparing the Japanese and US Bubbles.)
Europe's current debt crisis is just the latest example. The crisis was arguably triggered by unsustainable practices in countries like Iceland. Iceland is a very small country, but its banks saw an opportunity in accepting deposits from Europeans and turning them around for loans to hot markets, like Iberian real estate. As in the case of prior American bank crises, banks got too aggressive and lackadaisical in lending into an asset bubble.
Making matters worse for Europe, the Eurozone currency union led irresponsible governments and financial institutions to borrow excessively. The European currency union had the effect of granting much lower interest rates, and much higher access to capital, for countries like Greece, Spain, and Ireland, than would otherwise have been possible. This essentially let them take advantage of the stronger fiscal condition of fellow union members, like Germany and France.
Easy access to cheap money was too tempting for many governments and they borrowed extensively to fund a variety of public welfare programs. As the easy money period ended, though, these countries found themselves saddled with extensive levels of debt and without the ability to generate enough income to support repayment. Since 2010 there were repeated panics in countries like Greece, Ireland and Spain, as governments struggled to restructure their debt obligations and secure public acceptance of austerity programs, designed to facilitate eventual debt repayment.
InsightsTake a look at several of the most prominent financial crises of the 21st century, and understand why the Great Recession was a truly remarkable contraction.
InvestingA bank is a financial institution licensed to receive deposits or issue new securities to the public.
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InsightsA financial crisis is a situation in which the values of assets drop rapidly.
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