What are two reasons that banks failed during the Great Depression

In the fall of 1930, the economy appeared poised for recovery. The previous three contractions, in 1920, 1923, and 1926, had lasted an average of fifteen months.1 The downturn that began in the summer of 1929 had lasted for fifteen months. A rapid and robust recovery was anticipated. In November 1930, however, a series of crises among commercial banks turned what had been a typical recession into the beginning of the Great Depression.

When the crises began, over 8,000 commercial banks belonged to the Federal Reserve System, but nearly 16,000 did not. Those nonmember banks operated in an environment similar to that which existed before the Federal Reserve was established in 1914. That environment harbored the causes of banking crises.

What are two reasons that banks failed during the Great Depression
Chart 1: Total number of bank suspensions, 1921 to 1936. Data plotted as a curve. Units are banks per year. A vertical line at 1929 indicates the beginning of the stock market crash. A second vertical line at 1933 indicates the banking holiday of 1933. As the figure shows, the annual number of bank suspensions between 1921 and 1928 totaled less than 1,000. In 1929, the annual number of bank suspensions began to rise, peaking in 1933 before collapsing to near zero after the banking holiday. (Data: Federal Reserve Bulletin, September 1937. Graph created by: Sam Marshall, Federal Reserve Bank of Richmond)

One cause was the practice of counting checks in the process of collection as part of banks’ cash reserves. These ‘floating’ checks were counted in the reserves of two banks, the one in which the check was deposited and the one on which the check was drawn.2  In reality, however, the cash resided in only one bank. Bankers at the time referred to the reserves composed of float as fictitious reserves. The quantity of fictitious reserves rose throughout the 1920s and peaked just before the financial crisis in 1930. This meant that the banking system as a whole had fewer cash (or real) reserves available in emergencies (Richardson 2007).

Another problem was the inability to mobilize bank reserves in times of crisis. Nonmember banks kept a portion of their reserves as cash in their vaults and the bulk of their reserves as deposits in correspondent banks in designated cities. Many, but not all, of the ultimate correspondents belonged to the Federal Reserve System. This reserve pyramid limited country banks’ access to reserves during times of crisis.3  When a bank needed cash, because its customers were panicking and withdrawing funds en masse, the bank had to turn to its correspondent, which might be faced with requests from many banks simultaneously or might be beset by depositor runs itself. The correspondent bank also might not have the funds on hand because its reserves consisted of checks in the mail, rather than cash in its vault. If so, the correspondent would, in turn, have to request reserves from another correspondent bank. That bank, in turn, might not have reserves available or might not respond to the request.4

These problems turned the collapse of Caldwell and Company into a painful financial event. Caldwell was a rapidly expanding conglomerate and the largest financial holding company in the South. It provided its clients with an array of services – banking, brokerage, insurance – through an expanding chain controlled by its parent corporation headquartered in Nashville, Tennessee. The parent got into trouble when its leaders invested too heavily in securities markets and lost substantial sums when stock prices declined. In order to cover their own losses, the leaders drained cash from the corporations that they controlled.

On November 7, one of Caldwell’s principal subsidiaries, the Bank of Tennessee (Nashville) closed its doors. On November 12 and 17, Caldwell affiliates in Knoxville, Tennessee, and Louisville, Kentucky, also failed. The failures of these institutions triggered a correspondent cascade that forced scores of commercial banks to suspend operations. In communities where these banks closed, depositors panicked and withdrew funds en masse from other banks. Panic spread from town to town. Within a few weeks, hundreds of banks suspended operations. About one-third of these organizations reopened within a few months, but the majority were liquidated (Richardson 2007).

Panic began to subside in early December. But on December 11, the fourth-largest bank in New York City, Bank of United States, ceased operations. The bank had been negotiating to merge with another institution. The New York Fed had helped with the search for a merger partner. When negotiations broke down, depositors rushed to withdraw funds, and New York’s superintendent of banking closed the institution. This event, like the collapse of Caldwell, generated newspaper headlines throughout the United States, stoking fears of financial panics and currency shortages like the panic of 1907 and inducing jittery depositors to withdraw funds from other banks.

The Federal Reserve’s reaction to this crisis varied across districts. The crisis began in the Sixth District, headquartered in Atlanta. The leaders of the Federal Reserve Bank of Atlanta believed that their responsibility as a lender of last resort extended to the broader banking system. The Atlanta Fed expedited discount lending to member banks, encouraged member banks to extend loans to their nonmember respondents, and rushed funds to cities and towns beset by banking panics.5

The crisis also hit the Eighth District, headquartered in St. Louis. The leaders of the Federal Reserve Bank of St. Louis had a narrower view of their responsibilities and refused to rediscount loans for the purpose of accommodating nonmember banks. During the crisis, the St. Louis Fed limited discount lending and refused to assist nonmember institutions.

Outcomes differed between the districts. After the crisis, in the Sixth District, the economic contraction slowed and recovery began. In the Eighth District, hundreds of banks failed. Lending declined. Business faltered and unemployment rose (Richardson and Troost 2009; Jalil 2014; Ziebarth 2013).

The banking crisis that began with the collapse of Caldwell subsided in early 1931. A new crisis erupted in June 1931, this time in the city of Chicago. Once again, depositor runs beset networks of nonmember banks, some of which had invested in assets that had declined in value. In Chicago, the problem particularly involved real estate.

These regional banking crises harmed the national economy in several ways. The crises disrupted the process of credit creation, increasing the prices that firms paid for working capital and preventing some firms from acquiring credit at any price (Bernanke 1983). This process was particularly pronounced in regions, like the Eighth Federal Reserve District, where large numbers of banks failed, and the information that those banks possessed about who in their community was a good and a bad credit risk disappeared.

The crises also generated deflation because they convinced bankers to accumulate reserves and the public to hoard cash (Friedman and Schwartz 1964). Hoarding reduced the proportion of the monetary base deposited in banks. Accumulating reserves reduced the proportion of deposits that banks loaned out. Together, hoarding and accumulating reduced the supply of money, particularly the amount of money in checking accounts, which at the time were the principal means of payment for goods and services. As the stock of money declined, the prices of goods necessarily followed.

Deflation harmed the economy in many ways. Deflation forced banks, firms, and debtors into bankruptcy; distorted economic decision-making; reduced consumption; and increased unemployment. The gold standard transmitted deflation to other industrial nations, which contributed to financial crises in those countries, and reflected back onto the United States, exacerbating a deflationary feedback loop.

The deflation ended with the Bank Holiday of 1933 and the Roosevelt administration’s recovery programs. These programs included the suspension of the gold standard and the reflation of prices, discussed in essays on Roosevelt’s Gold Program and the Gold Reserve Act of 1934, as well as the reform of financial regulation, creation of deposit insurance, and recapitalization of commercial banks, discussed in essays on the Emergency Banking Act, Banking Act of 1933, and Banking Act of 1935.

In RDP 2001-07

The depression was ushered in by the drying up of overseas loans to Australia and a sharp fall in export prices. Australia's terms of trade fell dramatically, causing a balance of payments crisis in 1929. Like the depression of 1892, real GDP fell about 10 per cent in the first year of the depression 1931. The 1930s depression, however, was not as protracted. Growth resumed in 1932 and the level of real GDP recovered to its pre-depression level in 1934.

Unlike the 1890s, the financial system proved to be comparatively robust. Only three banks failed during the 1930s – two small trading banks (the Primary Producers Bank and the Federal Deposit Bank) and the Government Savings Bank of NSW. The Government Savings Bank was brought down by political turbulence as much as the economic conditions. While the Commonwealth Bank provided some limited support to two of these banks, it was later criticised for not taking a more active role, particularly since two of the banks were solvent when they suspended payment.

8.1 Trading Bank Failures

In 1930, the Primary Producers Bank of Australia accounted for less than 0.5 per cent of Australian banks' deposits. Most of its customers were farmers, and as the prices of primary produce fell the bank suffered a steady drain on its resources. Over the 18 months prior to the bank's closure, it lost 40 per cent of its deposits.

In April 1931, the bank sought the assistance of the Commonwealth Bank in anticipation of a run following the suspension of the Government Savings Bank. The Commonwealth Bank provided an unsecured overdraft of £100,000 and a loan of £295,000 secured by government bonds, a fixed deposit at another bank and the bank's premises. The Primary Producers Bank actively sought amalgamation with the other trading banks and overseas financial groups. While the Commonwealth Bank considered arranging joint action with the trading banks to avoid closure of the Primary Producers Bank, the other banks decided against the proposal. In the wind-up of the bank depositors were not quite fully paid, losing just 1.25 per cent of the value of their deposits (Royal Commission into the Monetary and Banking Systems 1937).

A few days following the closure of the Primary Producers Bank, the chairman of the Commonwealth Bank made a public statement in an attempt to prevent depositor withdrawals spreading to other banks:

…during the last few years the banking system of this country has been developed and strengthened through the recognition by the trading banks of the Commonwealth Bank as a central reserve bank…it must be prepared at any time to issue currency to its banker depositors, when called upon, and to render any assistance which is justified in the interests of national welfare…I suggest to depositors generally that they stand behind the institutions with which they have been doing business in the past…

The general uneasiness following the failure of the Primary Producers Bank and the suspension of the Government Savings Bank of NSW led to a steady loss of deposits from the Federal Deposit Bank. This bank was more a building society than a fully-fledged bank and accounted for less than 0.2 per cent of Australian banks' deposits. The directors of the bank sought assistance from the Commercial Banking Company of Sydney, which released fixed deposits the Federal Deposit Bank held with it and lent to the bank against its holdings of government securities.

As the Federal Deposit Bank continued to lose deposits, it applied for assistance from the Commonwealth Bank. The Commonwealth Bank took the view that the circumstances did not justify intervention. The Federal Deposit Bank suspended payment on 4 September 1931, and was taken over by the Brisbane Permanent Building and Banking Company. The Federal Deposit Bank's depositors were repaid in full in instalments over a number of years.

The day after the Federal Deposit Bank suspended payment, the Queensland Deposit Bank was subject to a heavy run. The bank withstood this run with aid from the National Bank of Australasia, which lent it £50,000 in bank notes (Blainey 1958).

In reviewing the Commonwealth Bank's handling of these failures, the 1937 Royal Commission into Australia's Monetary and Banking Systems argued that the Commonwealth Bank should have taken a more active role. In giving evidence to the Royal Commission, the Commonwealth Bank argued:

The central bank attitude must be dependent upon the general economic circumstances prevailing, the nature and cause of the trouble, the security position of the bank concerned, the general outlook and the other responsibilities of the central bank. In general, the central bank would be prepared to re-discount treasury-bills, to make advances against or to purchase London funds or advance against trade bills or government or other acceptable securities…

Although the tendency of recently established central banks is to extend the types of security eligible as the basis of central bank assistance, it is clear that it is customary for central banks to regard their obligations to other banks as strictly limited. The Commonwealth Bank, however, would in an emergency be prepared to give assistance to a bank which had conducted its business on prudent lines beyond the ordinary limits of central bank practice, provided that in making the loan it had some assurance that the bank concerned would punctually meet its obligations to the central bank.

This suggests that the Commonwealth Bank had both broader financial system stability and moral hazard considerations in mind. Since both trading banks that failed were small, and the contagion in terms of runs on other banks was well contained, it could be argued, with the benefit of hindsight, that there was no systemic case for providing last-resort support.

With regard to moral hazard considerations, the difficulty faced by the Commonwealth Bank was that its ability to monitor the behaviour of the other banks was quite limited. Even during the height of the balance of payments crisis in 1929, the Commonwealth Bank lacked the power to obtain data on individual banks' London funds. The Royal Commission acknowledged this to some extent, arguing that if the Commonwealth Bank found a troubled bank to be solvent it might undertake to guarantee the bank's deposits, provided it was given adequate security and some control over the bank.

Two other reasons might be advanced for the Commonwealth Bank's reluctance to provide stronger support. The first was a concern to conserve its own resources. This was borne out by the bank's objective that any recipient of assistance be able to repay its obligations. The second was that, although the bank's powers had gradually expanded during the 1920s, it remained relatively inexperienced in acting as a central bank. In 1929, when discussing the development of central banking, the directors of the Commonwealth Bank reported that ‘the establishment of the Central Reserve Banking System in Australia still remains an open question’. 1931 was the first time the Commonwealth Bank was called upon to act as a lender of last resort. The criticisms made by private banks regarding the conflict of interest arising from the combination of commercial banking and central banking within the Commonwealth Bank, which held back the accretion of the bank's central banking powers in the 1920s, also biased the bank towards being tentative in its relations with the other banks.

8.2 Savings Bank Failures

8.2.1 Government Savings Bank of New South Wales

During the depression, all savings banks lost funds as unemployment and wage cuts compelled depositors to draw on their savings. In the case of the Government Savings Bank of NSW, however, political uncertainty added to the economic depression, resulting in runs that forced the bank to close. This came at the time when the market share of government-owned savings banks had peaked at over 40 per cent of all banks' deposits (Figure 1).

Figure 1: Share of Bank Deposits

What are two reasons that banks failed during the Great Depression

Sources: Butlin (1953, 1986); Butlin, Hall and White (1971); White (1973) and Reserve Bank calculations.

The October 1930 NSW election campaign was fought between the incumbent Nationalist Party and the Labor Party led by JT Lang. Lang's policy was to oppose the deflationary economic program agreed upon by the Commonwealth and State Governments in July 1930, and to repudiate interest payments to holders of NSW Government securities. The Nationalist Party alleged that, if elected, Lang would commandeer savings held in the Government Savings Bank to finance its expansionary policies. These allegations prompted an acceleration in deposit withdrawals. The Government Savings Bank issued leaflets emphasising its independence from the government, which steadied the panic. It also asked the Commonwealth Bank if it would provide assistance if necessary, and what form such assistance might take. The Commonwealth Bank responded that the request was ‘too nebulous to be dealt with in a practical manner’. While the Labor Party's electoral victory triggered a brief spate of withdrawals, these were not as severe as those during the election campaign.

In February 1931, the NSW Treasury defaulted on interest payments and maturing government stock owing to the bank, the single largest holder of NSW Government securities. When news of the default became public, deposit withdrawals accelerated again. Confidence was further shaken when the Reduction of Interest Bill was introduced to Parliament on 18 March. The Bill proposed reductions in the rate of interest paid by the NSW Government on its own securities. The Government Savings Bank would have suffered a substantial cut in income, but the Bill was shelved on 25 March.

At the end of March, NSW defaulted on its interest obligations to British bondholders, but the Commonwealth Government stepped in and made the payments to preserve Australia's credit standing overseas. The default led to another surge in deposit withdrawals. The bank sought aid from the NSW Treasury, but received no cash. The bank, together with the Premier, placed advertisements in the daily newspapers assuring depositors that the bank was free from political control and their money had the backing of ‘all the assets of New South Wales’. This did little to slow the rate of deposit withdrawals, and if anything, strengthened the community's doubts (Polden 1970).

The bank sought specific assistance from the Commonwealth Bank, asking for funds and some reassuring statement by the Commonwealth Bank suggesting it would stand behind the bank. The Commonwealth Bank indicated it was not willing to make so large a guarantee (deposits of the Government Savings Bank were around £60 million, compared with the Commonwealth Bank's total assets of £52 million). However, it did indicate it was willing to prepay the fixed deposit the Government Savings Bank held with it and discount fixed deposits the Government Savings Bank had placed with other banks. This assistance totalled nearly £3 million, but was insufficient to meet continuing depositor withdrawals.

The Chairman of the Commonwealth Bank then suggested that the Commonwealth Bank would be prepared to consider amalgamating with the Government Savings Bank. On 21 April, the NSW Cabinet agreed to proceed with amalgamation. Lang publicly announced that he was seeking a takeover. The Commonwealth Bank's press statement, however, was non-committal, indicating that, while the bank was willing to explore the proposal, it had not committed to taking over the Government Savings Bank. The Commonwealth Bank had argued that no public statement should be made until the NSW Government had formally approved the proposal, the Commonwealth Bank had investigated the bank's accounts, and an approach had been made to the Federal Treasurer (Giblin 1951). The public statements by the State Government and the Commonwealth Bank triggered such heavy withdrawals (both from depositors concerned the Commonwealth Bank would not support the bank and those seeking to avoid any suspension of payment that may have come with the amalgamation) that the Government Savings Bank was forced to suspend payment on 22 April.

Once the Government Savings Bank had suspended payment, the Commonwealth Bank offered to make funds available to the Government Savings Bank to allow it to release the funds of the most needy depositors. Between 23 April and 27 July, the Commonwealth Bank advanced £1.8 million on this basis.

The shock of having their funds in the Government Savings Bank frozen led depositors to question the safety of other banks. A run on the Commonwealth Savings Bank (a division of the Commonwealth Bank) began on 1 May. On 3 May, the Chairman of the Commonwealth Bank, Robert Gibson, made a radio broadcast to assure the public of the bank's safety:

As the Commonwealth Bank has control of the note issue, it can command resources in the form of currency to any extent which in the opinion of the Bank Board is deemed necessary. It is, therefore, in the strongest possible position…I am authorized by the Prime Minister, Mr Scullin, to say that his Government will support the Bank Board in any measure which it deems advisable to take…The bank will never close its doors, so long as the nation itself stands!

The statement was effective in stopping the run.

During June and July 1931, negotiations to arrange an amalgamation were conducted between the Government Savings Bank, the Commonwealth Bank and the NSW Government. The Commonwealth Bank was concerned to ensure that its financial position was not jeopardised. Lang objected to conditions proposed by the Commonwealth Bank requiring the NSW Government to guarantee full payment of its obligations to the Government Savings Bank. The negotiations came to an impasse. At the end of July, Lang abandoned the request for amalgamation and submitted an application for a rehabilitation loan of £10 million. The Commonwealth Bank responded that it could not fund such a large sum, and that, in any event, depositors would rapidly withdraw their funds from the re-opened bank.

On 3 September, the Lang administration attempted to re-open the Government Savings Bank. By mid October, it was evident that this attempt had failed. A compromise amalgamation was announced on 23 November and effected on 15 December 1931. At first, some rationing of withdrawals from former Government Savings Bank accounts was imposed by the Commonwealth Savings Bank; but from 14 January 1932 depositors were permitted to draw freely against their balances.

8.2.2 Western Australia and South Australia

Two other state savings banks, in Western Australia and South Australia, sought the Commonwealth Bank's assistance in 1931. Unlike NSW, the governments were honouring their debts and the savings banks were not involved in substantial short-term financing of the state. As a result, the Commonwealth Bank was much more willing to provide support.

Loss of deposits from the State Savings Bank of Western Australia in September 1930 prompted the Western Australian Premier to approach the Commonwealth Bank to broach the possibility of amalgamation. But nothing came of this.

In August 1931, the State Savings Bank of Western Australia's liquidity fell further. The Western Australian Premier took immediate action and negotiated an amalgamation with the Commonwealth Bank in only 11 days. The conditions in Western Australia made it much easier for the Commonwealth Bank to agree to offer support than had been the case in NSW. The State Savings Bank of Western Australia had not suffered runs anywhere near as severe as the Government Savings Bank, and the Premier readily agreed to accept the conditions the Commonwealth Bank placed on the merger. When signs of a run became evident in late August, after the bank was already under agreement to amalgamate with the Commonwealth Bank, the Commonwealth Bank's Chairman made a radio broadcast promising to depositors of the State Savings Bank that ‘the Commonwealth Bank will see that you are paid’.

In October 1931, the Savings Bank of South Australia's liquidity fell sharply, but there was no evidence of an uncontrollable run. The Commonwealth Bank was concerned to conserve its own resources and to lend only as a true last resort when the State Bank of South Australia had exhausted its own liquid reserves. The Commonwealth Bank, therefore, offered to assist on the condition that the Savings Bank of South Australia first deplete its cash reserves of over £3 million. The bank refused to accept this condition, and was able to withstand its liquidity shortage without any further calls for assistance.

8.2.3 Discussion

The failure of the NSW Government's guarantee to prevent the closure of the Government Savings Bank highlights the fact that a credible lender of last resort needs to be able to readily generate liquidity. Throughout the life of the bank, the government guarantee was in the form of a claim upon the NSW Consolidated Revenue Fund. During 1931, the consolidated revenue could barely meet the essential demands of government. The weakness in the government guarantee was that the state government lacked the power to create high-powered money (which rested with the Commonwealth Bank).

Since it was clear that the Government Savings Bank was solvent, and given the possibility that the bank might have been able to avoid suspending payment if support had been provided earlier, it has been questioned why the Commonwealth Bank did not provide more support earlier. There are five main reasons why it did not.

First, the Board of the Commonwealth Bank was critical of Lang's radical policies and shied away from the political controversy that involvement with the NSW Government engendered. Gibson, speaking to a conference of savings banks after the Government Savings Bank closed said: ‘We could not stand behind the State Savings Bank of New South Wales in its recent trouble because it was occasioned by political insanity’.

Second, supporting the Government Savings Bank was seen to be a risky proposition. The NSW Government was the principal debtor or guarantor for about 70 per cent of the Government Savings Bank's investments and had already defaulted on interest payments. The Commonwealth Bank, therefore, was concerned to ensure its rights to repayments would be specifically guaranteed.

The third reason was that the Commonwealth Bank sought to avoid inflationary credit creation. Since consumer prices were falling at the time, the fear of inflation would seem to have been an unreasonable one; nevertheless it seems to have been influential. The Commonwealth Bank's ability to issue notes was subject to legislative limitation. In March 1931, the Commonwealth Bank held gold sufficient for it to issue an additional £13 million in notes. The bank, therefore, had sufficient resources to provide a considerable injection of liquidity into the Government Savings Bank. The Commonwealth Bank, however, eschewed such an expansionary policy. In November 1930, the Federal Government had put a series of proposals to the Commonwealth Bank asking it to create credit to finance the government deficit and the needs of private industry. Directors of the Commonwealth Bank emphasised that such a drain on banking funds would undermine the monetary system. In April 1931, the Commonwealth Bank indicated to the Government the limit beyond which it would provide no further credit. If not willing to extend more credit to the Commonwealth Government, the bank could hardly lend to the Government Savings Bank.

Fourth, just as the Commonwealth Bank was inexperienced in acting as a central bank for the trading banks, it had had little practice in providing central banking services to savings banks. During the 1920s, most attention was devoted to the Commonwealth Bank's role as banker to the trading banks; little consideration had been given to the savings banks.

Fifth, it has been suggested that the Board did not want to see the Government Savings Bank survive since it adhered to the policy that there should be only one savings bank (Giblin 1951). The Prime Minister, Andrew Fisher, on the establishment of the savings bank arm of the Commonwealth Bank in 1911, stated that ultimately there should be only one savings bank in Australia. In 1912, the Commonwealth Bank made offers to each state to take over their savings banks. It amalgamated with the Tasmanian State Savings Bank in 1913 and the Queensland Government Savings Bank in 1920 (Jauncey 1933). Polden (1970), however, argues that the Commonwealth Bank's actions were not so much influenced by a desire to remove a competitor as its lack of confidence in the NSW Government.