Banking crises and the Federal Reserve as a lender of last resort during the Great Depression.

• Author: Richardson, Gary

My research focuses on banking crises in the Great Depression, the structural flaws in the financial system that propagated the crises, the Federal Reserve's efforts to act as a lender of last resort, and the factors that shaped how policy-makers responded to the crisis. Research on these issues involves gathering documents from the archives of the Federal Reserve System as well as collecting information from state regulators and private firms.

My emphasis on institutions and data stems from a desire to identify the causes of the crises and the effects of a lender of last resort. These events and policies were, obviously, endogenous, making it difficult and at times impossible to clearly identify cause and effect. Identification is complicated because the factors that facilitate identification in financial theory consist of information--like the beliefs and expectations of economic agents and policy makers--that is difficult (and often impossible) to observe in practice and that exists in few of the records remaining from the 1930s.

Structural Weakness in the Commercial Banking System before the Great Depression

The NBER dates the onset of the Great Depression to August 1929. In the fall of 1930, 15 months after the onset of the contraction, the economy appeared poised for recovery. The previous three contractions, in 1920, 1923, and 1926, had lasted an average of 15 months. In November 1930, however, a series of crises among commercial banks turned what up to that time had been a typical recession into the longest and deepest contraction of the twentieth century.

When the crises began, over 8,000 commercial banks belonged to the Federal Reserve System, but nearly 16,000 did not. Those non-member 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.

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, and in many cases, additional banks, through which the check flowed through while clearing. In reality, however, the cash resided in only one bank. Bankers at the time referred to the reserves comprised of float as fictitious reserves. The quantity of fictitious reserves rose throughout the 1920s and peaked just before the financial crisis in 1930. Estimates vary, but in the fall of 1930, fictitious reserves probably accounted for more than half and possibly up to four-fifths of all reserves in non-member banks. This meant that the banking system as a whole had a limited amount of cash reserves available for emergencies (1).

Another challenge was the inability to mobilize bank reserves in times of crisis. Non-member 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. 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. (2)

It should be noted that these flaws had been apparent to the founders of the Federal Reserve. Paul Warburg wrote about them even before the financial crisis in 1907. The National Monetary Commission described them in its series of reports. The initial leaders of the Federal Reserve System discussed them in their writings and explained how the structure of the Federal Reserve and the actions of its leaders solved these problems for member banks. But--here is a key part of the story--the Federal Reserve solved these problems only for member banks. For this reason, Warburg urged all commercial banks to...