The Effect of Bank Failures on Economic Activity: Evidence from U.S. States in the Early 20th Century

Abstract

This paper provides evidence documenting the existence of a “bank failure channel”—the magnifying effect of bank failures on economic distress—using state‐level quarterly time series from 1900q1 to 1929q4. We estimate a vector autoregression model of bank failures for each state. The forecast‐error variance decompositions are used to construct a categorical measure of the “bank failure channel.” We examine the influence of regulatory variables, economic conditions, and banking conditions on the degree to which bank failures propagate distress. State‐sponsored deposit insurance and minimum capital requirements are important for explaining the likelihood of having a bank failure channel.