An Examination of Country Member Bank Cash Balances of the 1930s: A Test of Alternative Explanations.

• Author: Mounts Jr., Wm. Stewart

Wm. Stewart Mounts [+]

Clifford B. Sowell [+]

Atul K. Saxena [++]

Around March 1933, commercial banks began accumulating unprecedented amounts of cash. Uncertainty over deposits and loans, low interest rates relative to brokerage fees, and costly de novo capital have been used to explain this behavior. This paper employs aggregate call-date data for country member banks in the 12 Federal Reserve districts to formally investigate the role of these factors in the accumulation. The results indicate a minimal, if any, role for these factors. The findings suggest that it was the unintended consequence of unprecedented deposit growth in the face of large scale-related adjustment costs.

1. Introduction

   Around the Emergency Banking Act of March 9, 1933 (the "bank holiday"), banks began accumulating unprecedented amounts of cash assets. [1] Figure 1 shows this for country member banks in a sample of Federal Reserve districts. [2] Table 1 documents this run-up relative to other assets at the country bank level for selected call dates. As shown, cash remained a relatively stable percentage of total assets through the December 1932 call date, whereas loans and securities changed over the business cycle. [3]

   Explanations of this phenomenon may be found in the seminal work of Friedman and Schwartz (1963), Morrison (1966), Frost (1971), Ramos (1996), and Calomiris and Wilson (1996), with the macroeconomic framework of Bernanke (1983) being tangential. Each argues in some way that the accumulation of cash was desired and driven primarily by uncertainty over future bank runs, low (relative to brokerage fees) interest rates, uncertainty over loan payback, or by high costs of adding de novo bank capital.

   The purpose of this paper is to present an alternative explanation for the cash accumulation within an empirical examination of the existing literature. Our principal point of differentiation turns on whether the cash accumulation was desired. Except for Bernanke (1983), the literature treats the cash buildup as desirable or something toward which bankers were indifferent. Whether it was accumulated to protect against runs or massive loan failures or to signal bank solvency or was the result of low net (of transactions costs) yields on securities, no clear distinction is made between actual cash holdings and target cash holdings.

   Why does this distinction matter? Consider, for example, a passage from Ramos (1996):

   During the 1930s, rather than redundant, banks' excess reserves were desired and were performing an economic function. Holding such amounts of cash was a profit maximizing decision. (p. 473)

   As will be shown, the cash buildup was not due to an asset reallocation with a fixed deposit base but from a significant deposit inflow after the holiday. While loans and securities would have been acquired because of their return relative to non-interest-bearing cash and the need for cash flow, the recent work of Ramos (and Calomiris and Wilson 1996 for that matter) argues that the need to signal solvency was a significant component of bank decision making. Assuming that acquiring de novo capital (an alternative signal of solvency) was costly, the cash accumulation produced benefits unavailable elsewhere and, as such, was desired. To Friedman and Schwartz (and Morrison) it was desired because of the uncertainty over the Fed's willingness to be the lender of last resort and to Frost it was the desired (or natural) result from a simple asset substitution driven by net security yields of zero. [4]

   However, what if solvency signals or uncertainty were not significant components in decision making? What if net security yields were not zero? With the absence of these factors, bankers would have sought to minimize cash given that it produced no significant benefits other than those offered under periods of normal banking operations.

   Alternatively, low target levels would have been set, and security and loan assets would have been acquired. To do this, costs would have been incurred, especially with respect to loans. Two sources of costs need to be identified. First, there are those costs associated with managerial, administrative, and general day-to-day banking activities--costs directly related to the creation of interest-earning assets. We refer to these as "scale-related costs" in that it seems reasonable to expect these costs, like any cost of production, to be subject to diminishing returns because of the fixed nature, or scale, of the banking enterprise. Next, as found in Bernanke's (1983) "cost of credit intermediation" explanation of the Depression, there are also informational costs directly related to the inherent uncertainty of loan payback and collateral values. If this uncertainty over loans was not a significant factor in decision making, then the creation of loans and other assets would have been constrained largely by sc ale-related costs.

   Given that the closings of the holiday had the effect of increasing market share for the remaining licensed banks, the large and possibly unanticipated deposit inflow would have encouraged banks, at some time, to expand. However, banking laws at the time limited expansion through unit banking laws and the like, restricting the production function and thereby asset creation. Thus, the impact of scale-related costs may have been significant in the buildup of cash assets.

   The importance of scale-related costs is an empirical question, as is the importance of uncertainty, solvency, and so on. Our examination is framed around the model of cash management under uncertainty of Baltensperger and Milde (1976). Unlike the existing literature, a specific measure of uncertainty is included in the estimation. As will be developed, the absence of an explicit treatment of uncertainty may have kept the estimated role of interest rates from being appropriately measured. In addition, since the appearance of Frost (1971), Cecchetti (1988) has published a series of Treasury security yields that have been adjusted for an 'exchange privilege," a common feature of the securities of the time. It will be argued that the use of these yields introduces brokerage fees into the estimation, allowing for an accurate test of Frost's low-interest-rate argument.

   The presentation is arranged as follows. The first part of section 2 reviews the entrenched and contemporary literature, while the second part critiques it within a historical setting. Several of the arguments found in the literature seem inconsistent with historical events and trends exhibited by the aggregate country member bank call-date data. Section 3 develops the model of Baltensperger and Milde (1976) as an appropriate framework for testing the alternatives. Also, the nature of the data is examined and the estimation procedure described in this section. Results are discussed in section 4. In general, contrary to the literature, uncertainty over deposits and loans appears to have played only a minor role in the accumulation of cash. Further, the demand for cash does not exhibit a kink, even after employing Treasury yields that have been adjusted for brokerage fees. In addition, the results indicate that cash was not a timely substitute to costly equity. What is consistent across the districts is (i) a g enerally slow but varied speed of adjustment in reaching target levels of cash and (ii) the failure of country member banks to accurately forecast cash inflows. Both imply that the accumulation at the country member bank level was the result of unprecedented deposit growth beginning with the bank holiday in the face of significant scale-related adjustment costs. These results are consistent with a partial or limited view of the "cost of credit intermediation" of Bernanke (1983). Section 5 offers some conclusions.

2. Previous Studies and Historical Considerations

   Previous Studies

   In their seminal work, Friedman and Schwartz (1963, pp. 449-62) argued that previous periods of bank runs and financial panics of the 1920s and, particularly, the early 1930s shocked bankers into expecting large deposit outflows. From this perspective, the accumulation of cash after the bank holiday served as a form of "protective liquidity" against anticipated runs and against uncertainty in general. The desire for liquidity was amplified further by the narrowing gap between market interest rates and the Fed's discount rate. In some months during the 1930s, the gap was even negative; a penalty on discount window access communicated an unwillingness by the Fed to be the lender of last resort.

   In a related study, Morrison (1966) used a model of transitory deposit potential and found support for the Friedman and Schwartz protective liquidity hypothesis. Part of his analysis compared the structure and experiences of the banking system in the United States with that of Canada. The United States, with its dependency on unit banking, was more susceptible to periodic bank runs relative to the national branch banking of Canada. [5]

   Elsewhere, Frost (1971) argued that there was a kink (as opposed to a shift, as argued by Friedman and Schwartz and by Morrison) in the demand for excess reserves. In this "interest rate/brokerage fee hypothesis," the observed accumulation of cash assets after the bank holiday was driven primarily by nominal interest rates being below some critical level. Given that brokerage fees had to be paid to acquire securities, it made sense to simply accumulate cash once interest rates fell below some level relative to the fees. [6] In such instances, the net effective yield on security assets would be zero. [7]

   Bernanke (1983) indirectly addressed the accumulation of cash through loan uncertainty in his "cost of credit intermediation" macroeconomic analysis of the 1930s. Bernanke argued that during the Depression the channels of information used to determine loan payback probabilities and to forecast the future value of collateral became distorted and...