Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930

Abstract

This paper investigates the effect of bank failures on economic growth using data from 1900 to 1930, a period that predates active government stabilization policies and includes periods of banking system distress that are not coincident with recessions. Using both VAR and a difference-in-difference methodology that exploits the reactions of the New York and Connecticut economies to the Panic of 1907, we estimate the effect of bank failures on economic activity. The results indicate that bank failures reduce subsequent economic growth. Over this period, a 0.14 percent (1 standard deviation) increase from the mean value of the liabilities of the failed depository institutions results in a reduction of 17 percentage points in the growth rate of industrial production and a 4 percentage point decline in real GNP growth. The reductions occur within three quarters of the initial bank failure shock and can be interpreted as an important component of the cost of systemic risk in the banking sector.