Who’s Afraid of the Big Bad Banks?
Bryan Taylor, Chief Economist, Global Financial Data
The recent seizure of both Silicon Valley Bank and Signature Bank by the FDIC as well as the takeover of Credit Suisse by UBS has put the market on edge. Fear that the financial contagion could spread to other regional banks or to Europe has driven the price of many banks down in price by over 30%. Although regional banks have recovered, there is fear that more banks may fail. Although the Fed raised interest rates by a quarter point, the Fed has also offered to pump money into banks by valuing their bonds at face value rather than their market value when they are used as collateral.
Some investors are concerned about the stability of the banking system and fear that other banks will collapse soon; however, concerns about the stability of banks and the financial system may slow the increase in interest rates in the future. The yield on both 2-year and the 10-year US government bonds has declined since SVB and Signature Bank were taken over by the FDIC.
Are these concerns legitimate? Absolutely.
Many of the financial crises and bear markets in the past were driven or exacerbated by bank failures. Financial failures have played a role in almost every major bear market in the past. This article briefly goes over the history of bank failures to show how they have affected financial markets in the past.
The Panics of the 1800s
The Panic of 1825 occurred in Britain and led to the failure of 70 banks, many of which were small, country banks. The panic nearly took down the Bank of England itself. The Banque de France provided an infusion of gold reserves to the Bank of England to help keep it afloat. The boom in the 1820s was driven by investments in the newly independent Latin American countries and from capital freed up by the conclusion of the Napoleonic Wars. However, some money flowed into fictitious investments, such as the non-existent country of Poyais (see “The Fraud of the Prince of Poyais on the London Stock Exchange”) as well as South American mining companies that collapsed when the mines did not produce as anticipated. The Panic of 1825 was the first major stock market decline to follow the end of the Napoleonic Wars, but it was the first of several panics that occurred in the 1800s. The decline from the Panic of 1825 in London is illustrated in Figure 1.
Figure 1. GFD UK-100 Price Index from 1815 to 1835
The Panic of 1837 was in part caused by the non-renewal of the charter of the Second Bank of the United States. There was a run on banks in New York City on May 10, 1837 and the banks ran out of gold and silver and suspended specie payments. Nearly half of all banks failed, and the recession continued for the next four years. Many individual states, such as Michigan and Mississippi, defaulted on their bonds. The economy started to recover in 1838, but when England and the Netherlands raised interest rates, the economy started its decline once again. When the American market hit bottom in 1843, the United States ended its longest bear market in history which had begun in 1792.
Figure 2. GFD US-100 Price Index from 1830 to 1845
The Panic of 1857 was the first worldwide economic crisis that spread from the United States to Europe (see “The Ohio Life Insurance and Trust Co. and the Panic of 1857”). The price of railroad stocks peaked in July 1857. On August 24, 1857, the Ohio Life Insurance and Trust Co. announced that its New York branch had suspended payments. The company declared bankruptcy and depositors became concerned about the safety of their money at other banks. The SS Central America was bringing gold to New York to replenish the banks’ supplies, but it sank on September 12, 1857 and all of its gold along with 425 passengers sank to the bottom of the ocean. The price of railroads and grains continued to fall and the economy fell into a recession. Three banks in England, the Borough Bank of Liverpool, Western Bank of Scotland and city of Glasgow Bank failed. The panic spread to Germany and Scandinavia. It wasn’t until the start of the Civil War that the economy started to recover. The collapse of the Ohio Life Insurance and Trust Co. can be seen at the end of Figure 3.
Figure 3. The Ohio Life Insurance and Trust Co., 1835 to 1857
The failure of Overend, Gurney and Co. in London in 1866 set off a financial panic that spread throughout Europe (see “Overend, Gurney & Co.: An Inspiration to Karl Marx and Bear Stearns”). Overend, Gurney and Co. was the largest dealer in secondary paper in London after the Bank of England. It made a number of bad investments and when the Bank of England looked into bailing out the bank, they realized that they would just be pouring money down a black hole. The Bank of England declined to save them. Overend, Gurney and Co. failed and the panic spread to the continent. Since the bank had not collected the capital for its shares, shareholders were liable for the losses of the company. Someone could have bought a share for 10 pounds, but have to pay out 20 pounds to compensate the depositors who lost their money in the bank. In the first case of its kind, the directors of Overend were charged with financial fraud, but they were acquitted in 1869. The panic subsided in 1867 and the economy started to recover, but the panic of 1866 was not soon forgotten and became the focus of Walter Bagehot’s book Lombard Street: A Description of the Money Market which he published in 1873. Overend, Gurney and Co.’s brief history on the London Stock Exchange is provided in Figure 4 from its debut until its collapse.
Figure 4. Overend, Gurney and Co., 1865 to 1866
Banking panics in the United States in both 1873 and 1884 caused further problems for the stock market. The Panic of 1873 affected banks in the United States. In the US, both Jay Cooke & Co. and Henry Clewes’ banks failed. The situation in the stock market became so severe that it closed for ten days. The Vienna Stock Exchange crashed on May 9, 1873. The conversion of Germany, the United States and other countries from silver to gold contributed to the problems in the market. The 1884 panic was caused by the collapse of Grant and Ward and the Marine National Bank. Owners of both banks lost money in speculative investments which did not pay off. John Chester Eno’s embezzlement of over $3 million from the Second National Bank added to the problems. The panic was limited to New York City banks, and did not spread to the rest of the country. The two panics in 1873 and 1884 can be seen in Figure 5.
Figure 5. GFD US-100 Price Index, 1870 to 1890
Panics Across the World
The collapse of l’Union Gėnėrale bank in 1882 led to one of the few panics that occurred in Paris in the 1800s. The bank had been created in 1878 and financed the first railroad in Serbia, acquired insurance companies and created the Lyons Water and Lighting Co. In 1882, due to overcapitalization of securities, poor financial management, bad investments and battles between bulls and bears over its stock, the bank collapsed and was the principal cause of the Paris Bourse Crash of January 1882. The result was a recession that lasted until the end of the decade in France. The Panic in 1882 and the seven-year decline that followed can be seen in Figure 6.
Figure 6. France CAC All-Tradable Index, 1870 to 1900
The Panic of 1890 was caused by the near insolvency of Barings Bank in London. The bank made poor investments in Argentina and when the country defaulted on its debts, Barings Bank was nearly pushed into bankruptcy. An international consortium assembled by the governor of the Bank of England which included most of the major banks in London created a fund to guarantee Barings Bank’s debts. Without this intervention, the entire banking system of London could have collapsed. The Barings Crisis provided a model for resolving future bank crises.
The “Rich Man’s” Panic of 1907 was instrumental in establishing the Federal Reserve Bank of the United States. An attempt to corner the market of the United Copper Co. in October 1907 triggered the Panic of 1907. The collapse of the United Copper Co. is starkly visible in Figure 7.
Figure 7. The United Copper Co., 1902 to 1914
The Knickerbocker Trust Co., then the third largest trust company in New York City, failed. This put several similar trust companies on the brink of bankruptcy, but J.P. Morgan intervened, getting other banks to provide money to a fund to bail out banks that were on the edge of bankruptcy. The banks agreed to accept checks on other banks, but not provide cash to depositors to keep money within the banking system and keep other banks from failing. There was fear that the stock market would have to close on October 24, 1907, but in 15 minutes, Morgan was able to get 14 bank presidents to pledge almost $25 million to keep the stock market open. And it did.
Morgan and the bankers worked over the weekend to prepare for the opening of the stock market on Monday and when the market opened, trading resumed as normal. The solutions worked, but many people were upset that J.P. Morgan, a single person outside of the government, could wield such power. This led to the creation of the Pujo Committee to investigate the Panic of 1907 and make recommendations on how to deal with future problems. Ultimately, this led to the creation of the Federal Reserve in 1913. The Panic of 1907 can be seen in Figure 8 which shows the Dow Jones Industrial Average from 1900 to 1910.
Figure 8. Dow Jones Industrial Average from 1900 to 1910
The Great Depression
During the 1920s, over 6000 banks failed in the United States, and during the 1930s, over 9000 banks failed. Many of them were closed down in 1933 when every bank was inspected by the Federal Government after a nationwide bank holiday was declared. Most of the banks that failed were small, but New York’s Bank of the United States collapsed in December 1931 with over $200 million in deposits. Before 1933, there was no federal insurance of bank deposits, but the FDIC was introduced in 1934 and provided $5,000 in deposit insurance beginning on July 1, 1934. The collapse of banks in the United States is illustrated in Figure 8 where a decline of over 90% in bank stocks between 1929 and 1932 can be seen.
Figure 9. S&P Bank Index, 1920 to 1940
The biggest collapse in Europe was the Creditanstalt Bank in Vienna (see “The Collapse of the Creditanstalt Bank”). The Austrian banking system had become very concentrated by 1931, and the Creditanstalt represented 27 percent of the Austrian banking sector’s total assets equal to 16 percent of Austrian GDP. When the Creditanstalt declared on May 11, 1931 that it was unable to publish its financial statements for 1930, panic ensued. Austria’s central bank, the Oesterreichische Nationalbank, had to engineer a rescue of the bank, and its collapse led to runs on banks in Hungary, Czechoslovakia, Romania, Poland and Germany. England and the Scandinavian countries went off the Gold Standard and stock exchanges temporarily closed in Germany and Hungary.
Figure 10. Oesterreichische Creditanstalt Stock, Vienna, 1928 to 1931
Banking Crises Since the 1980s
After the FDIC was established in the United States in 1934, the number of banks that fell into bankruptcy declined dramatically. It wasn’t until the 1980s that the threat of bank failures once again threatened financial markets. The first threat occurred with the Latin American Banking Crisis of 1982. Petrodollars were recycled from OPEC countries to Latin American and other countries that needed cash. The money was recycled through international banks, but by 1982 the debt level of the borrowers had reached $327 billion. In August 1982, Mexican Finance Minister Jesus Silva Herzog informed the Federal Reserve Chairman, the US Treasury Secretary and the IMF that Mexico would no longer be able to service its debt. The crisis spread to other countries and the US took the lead as an “international lender of last resort.” To some degree this only delayed the problem and in 1989, the Brady Plan forgave over $61 billion in loans and put the developing countries on a firmer footing.
Rising interest rates in the United States led indirectly to the Savings and Loan Crisis. As interest rates rose, S&Ls began to suffer large losses which accumulated over time. It was estimated that it would cost $25 billion in 1983 to pay off the insured depositors of failed institutions, but the government allowed the problem to fester and by the time the government finally dealt with the Savings and Loan crisis in 1989 by passing the Financial Institutions Reform, Recovery and Enforcement Act, the cost had increased to $125 billion. 747 S&Ls with assets of over $407 billion were eventually closed. Similar problems occurred in Norway between 1988 and 1992 and in Sweden between 1990 to 1994 almost leading to the failure of their banking systems. The Asian Crisis in 1997 and Russia’s default in 1998 created problems in those countries as well.
The biggest problem, however, was the Global Financial Crisis of 2008. This was the most serious financial crisis since the Great Depression. It was caused by a combination of predatory lending which targeted low-income homebuyers, excessive risk-taking by global financial institutions and the bursting of the housing bubble in the United States. This ultimately led to the bankruptcy of Lehman Brothers, the liquidation of Bear Stearns (which was acquired by JPMorgan), support to Northern Rock Bank by the Bank of England, the failure of IndyMac and Washington Mutual, the Federal Reserve takeover of Fannie Mae and Freddie Mac, the failure of all the major banks in Iceland, and a bailout for Swiss Banks UBS AG and Credit Suisse (the former took over the latter in 2023).
The aftermath was a $700 billion bailout by the US government, the passage of the Dodd-Frank Act, the reduction of short-term interest rates to zero by the Fed, the use of quantitative easing to keep bond markets afloat, and a European debt crisis in 2012. Interest rates were kept low for the next five years.
Conclusion
So who is afraid of the Big Bad Banks? Investors are.
Anyone who studies history knows that banking problems can lead to problems in all financial markets, not only the stock market, but bond markets as well. Central banks have a responsibility to keep the rot from spreading, to contain any banking crisis and keep it from affecting the rest of the economy, to prevent a $25 billion S&L crisis in 1983 from developing into a $125 billion crisis in 1989. So far, central banks and government officials have acted quickly to prevent the 2023 crisis from spreading to other parts of the economy and the world, but whether they have prevented future problems from potential bank failures remains to be seen.
