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ISSUES IN FINANCIAL REGULATION
W orking Paper Series

Is the Banking and Payments System Fragile?
George J . Benston and George G. Kaufman

FEDERAL RESERVE BANK
OF CHICAGO



WP- 1994/28

Is th e B a n k in g a n d P a y m e n ts S y s te m F ra g ile ?
George J.Benston and George G. Kaufman*
In his introduction to The Risk of Economic Crisis, a compilation of papers
presented at a conference sponsored by the National Bureau of Economic
Research (NBER), Martin Feldstein (1991, p. 1) recognizes that, despite the
inability of less developed countries to service their debts, the massive
collapse of savings and loan associations in the United States, wide swings in
currency exchange rates, the increase in corporate and personal debt, and the
stock market crash of 1987, we have not suffered an economic crisis in recent
years. Nevertheless, he asserts (ibid., pp. 1-2):
But the risk of such an economic collapse remains. As Charles
Kindleberger's distinguished and fascinating book (Manias,
Panics and Crashes: A History of Financial Crises [Basic
Books, 1978]) has ably demonstrated, economic crises have
been with us as long as the market economy. At some point,
greed individual investors take greater risks in the pursuit of
greater returns. A shock occurs and the market prices of assets
begin to collapse. Bankruptcies of leveraged individuals and
institutions follow. Banks and other financial institutions fail in
these circumstances because they 7 are inherently leveraged.
The resulting failure of the payments mechanism and the
inability to create credit bring on an economic collapse.
He goes on to conclude (ibid.,p. 2):

*Benston is John H. Harland Professor of Finance, Accounting, and
Economics, Emory University and Kaufman is John F. Smith Professor of
Banking and Finance, Loyola University of Chicago and Consultant, Federal
Reserve Bank of Chicago. Both Benston and Kaufman are members of the
Shadow Financial Regulatory Committee. An earlier version of this paper
was presented at a Conference on Financial Fragility at the University of
Limburg, Maastricht, The Netherlands on September 7-9, 1994. The authors
are indebted to participants at the conference and to Douglas Evanoff for
helpful comments that improve the paper.

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The public interest in avoiding the failure of banks and other
financial institutions argues strongly for government regulation
and supervision of these institutions. Even Adam Smith
explicitly
advocated
the
regulation
of
banks because he recognized that their failure would have
damaging effects on the economy more generally.
Feldstein explains further his argument for regulation, as follows (ibid., p. 15):
The banking system as a whole is a "public good" that benefits
the nation over and above the profits that itearns for the banks'
shareholders. Systemic risks to the banking system are risks for
the nation as a whole. Although the managements and
shareholders of individual institutions are, of course, eager to
protect the solvency of their own institutions, they do not
adequately take into account the adverse effects to the nation of
systemic failure. Banks left to themselves will accept more risk
than is optimal from a systemic point of view. That is the basic
case for government regulation of banking activity and the
establishment ofcapital requirements.
These statements by a distinguished economist chair professor at Harvard,
President and Chief Executive Officer of the NBER, and former chairman of
the President's Council of Economic Advisers which are repeated in substance
by many other economists, bankers, legislators, regulators, members of the
general public, and in particular by central bankers, serve to motivate our
paper. Is the banking and payments system unusually fragile? Are depository
institutions (hereafter, simply called "banks") really prone to failure more than
are other firms and, if so, is the failure of one or several banks contagious,
giving rise to banking panics, the collapse of the financial system, and severe
damage to the macroeconomy? Do losses suffered by depositors in bank
failures have more adverse impact on eitherother banks or the macroeconomy
than losses suffered by creditors in the failures of nonbank firms have on other
firms in the same industry and beyond?
Furthermore, has banking become increasingly subject to international
contagion? This concern was well expressed by the then president of the
Federal Reserve Bank of New York to the Seventh International Conference
of Banking Supervisors: "the speed, volume, value, and complexity of
international banking transactions have introduced new linkages and
interdependencies between markets and institutions that have the potential to

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transmit problems and disruptions from place to place and institution to
institution atalmost breakneck speed" (Corrigan, 1992, p. 6.)
In section 1, we consider the theories that appear to underlie Feldstein’s and
many other observers' belief that the banking and payments system is
inherently unstable and prone to failure. Fractional reserve banking,
discussed in section 1.1, has long been identified as the primary reason for this
instability. In such a banking system, when there is no central bank or when
the central bank isineffective, instability may arise from runs on banks. Such
runs may result from unexpected withdrawals of demand deposits and bankissued currency because of depositors' concerns about their banks' solvency or
from exogenous outflows of reserves that threaten banks' solvency by forcing
rapid liquidation of assets at fire-sale losses. The banking system also might
suffer a contraction from bank insolvencies resulting from their lending
practices. We then discuss the relevance of the banking instability to
countries with deposit insurance or an effectively run central bank.
In section 1.2, we describe and analyze the sources of fragility in fractional
reserve banking that may threaten the survival of the banking system as a
whole. Four sources are identified, each of which implies somewhat different
public policies: (1) excessive expansion of credit; (2) asymmetric information
resulting in inability of depositors to value bank assets correctly, particularly
when economic conditions worsen; (3) shocks originating outside the banking
system that are independent of the financial condition of banks and either
cause depositors to change their liquidity preferences or cause reductions in
bank reserves (high-powered money); and (4) institutional and legal
restrictions that weaken banks, making them unnecessarily prone to failure.
In all of these scenarios, deposit withdrawals produce instability in the
banking system only ifthey cause a reduction in aggregate bank reserves. If
the withdrawals are redeposited at other banks, there may be costly churning
and some deadweight losses, but no threat to the survival of the banking or
payments system.
Following the explication and discussion of theories of banking and payments
system instability in section 1, we review much of the empirical research on
the sources of bank failures and banking panics in section 2. This review
leads us to conclude that the primary causes of past failures has been reasons
(3) and (4) exogenous withdrawals of bank reserves (largely gold), and
institutional and legal restrictions (primarily on U.S. banks). Thus, we do not
view banks and the banking system as inherently fragile. Nor, in the absence
of poorly operating central banks or undue imprudent restrictions on bank

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activities, do we find that bank failures are any more contagious or any more
costly than failures in other important industries.
These conclusions do not hinge on the existence of credible deposit insurance.
They hold equally well in a world without such insurance. Moreover, in most
countries, at least de jure insurance is incomplete so that some
depositors/creditors (those with accounts over $100,000 in the United States)
remain at risk and have incentives to run and ignite panics. The evidence on
contagion isreviewed in Section 3.
Bank failures, though, might be costly, such that the benefits from preventing
them with government action might be worth the cost. W e examine these
costs in section 4, and conclude that preventing individual or a small number
of bank failures is likely to be more costly than allowing them to occur. In
section 5, we discuss the role of the lender of last resort, either as a direct
lender to individual banks experiencing liquidity problems or as a supplier of
liquidity to the banking system.
From our review of the evidence on contagion and from our analysis of the
means by which central banks and changes in legal restrictions can prevent
the money supply and bank credit from declining, we conclude in section 6
that banking is not a "public good" and that the fragility of the banking and
payments system should not be a public concern, other than for preventing
actions, including those by the government, that either directly or indirectly
increase the risk profile of banks or the potential losses from bank failure to
other banks or the government (taxpayers). It is losses to non-contracting
third parties (externalities) from bank failures, not bank failures per se, that is
of primary public concern. These can be virtually eliminated by imposing a
capital requirement on banks, made effective by a system of structured early
intervention and resolution. Other restrictions on banks' activities should be
removed, as these make the banking and payments system less efficient and
individual bank failures more likely and more costly.

1. Theories of Banking and Payments System Instability
1.1. The Potential Instability of Fractional Reserve Banking
All firms might fail. Firms fail when they invest in products and processes
that turn out through time to generate a smaller cash flow than the amount
required to pay bills and service debt, so that eventually their net worth

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declines below zero. Some failures are the result of frauds. For example, the
promoters or managers of nonfinancial firms may claim that they have made
potentially veiy profitable discoveries that do not, in fact, exist. Nonbank
financial firms may practice a Ponzi scheme, where they pay early investors
high returns to entice new investments which are used to pay the high returns,
until the scheme collapses. None of these situations is new, and all continue
to the present day and, most likely, will be with us in the future.1
Banks differ from other financial institutions and nonbank firms in several
ways that make them more prone to failure. They are funded predominantly
by short-term and demand debt (deposits) primarily to satisfy the demand for
such par value securities by households and business firms. They usually hold
assets that cannot be sold quickly except at substantial discounts from par
(loans) or that have fixed-interest rates and longer maturities (bonds and
mortgages). Because banks typically hold relatively low levels of capital,
rapid withdrawals of deposits (runs) that force equally rapid liquidation of
assets or declines in the value of assets for other reasons can render banks
economically insolvent. Thus, banks are more fragile than financial or
nonfinancial firms that are proportionately less funded by short-term debt and
more funded by equity (less leveraged). Each of these sources of potential
instability deposits and assets is considered in the next two sub-sections.
The relevance of these concerns to countries with deposit insurance or an
effectively run central bank isdiscussed in the third sub-section.

1.1.1. Instability of Deposits and Bank Currency
If banks are perceived to be generating losses that threaten their net worth,
creditors (depositors) can withdraw their funds very quickly. In response,
because banks operate on a fractional reserve basis, holding only small
amounts of cash, they might have to sell assets quickly, even if they have
made borrowing arrangements with other (correspondent) banks. To the
extent that some of their assets are not highly liquid because they have longer
maturities, lower credit quality, and are customized, fire-sale losses are likely
to be incurred.2 Because banks typically hold relatively small amounts of
capital, these fire-sale losses may render them insolvent. Thus, a liquidity
problem may turn into a solvency problem.
In the normal course of events, the holders of bank liabilities (henceforth,
depositors) have no reason to fear that theirdemands for repayment would not
be met; if they did, they would not have deposited their funds in the bank.
However, ifdepositors believe that their bank has or even might experience a

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loss in asset values that would be sufficient to render the bank insolvent, they
have incentives to withdraw their funds immediately to run. Because fears
of insolvency atone bank raiseconcerns about insolvency atother banks, runs
are widely perceived as being contagious. When many depositors run on
many banks atonce, a "banking panic" issaid to result.
It is depositors' ability and, perhaps, propensity to run that is the basis for
many people believing that the banking system is fragile. Because banks'
deposit liabilities frequently serve as the means of payment (bank notes in
earlier times, demand and possibly savings and time deposits in the twentieth
century), the presumed fragility of banks implies a concomitant fragility of the
payments system.
As banks increasingly process payments among depositors in countries around
the world, concerns also have arisen about the vulnerability of domestic
payments systems to bank failures in other countries. A foreign bank might
fail, and thus not transmit payments for funds for which domestic banks
already have given depositors or other banks credit as occurred in the failure
of the Herstatt Bank in Germany in 1974. Conversely, the receiving banks
might be unable to pay other banks with claims on them. At the least, a costly
unraveling of claims might be required. Thus, a domestic payments system
might be disrupted because a foreign bank failed.

1.1.2. Instability of Bank Lending and Losses on Bank Assets
Banks that invest in long-term fixed-interest obligations subject themselves to
interest-rate risk, to the extent that these obligations are funded with short­
term and demand liabilities. Should interest rates increase, the value of the
banks' assets will decline more than the value of their liabilities, and they
could be rendered economically insolvent. Such was the situation for U.S.
savings and loan associations and mutual savings banks in 1979-1981.
Some contemporary observers, such as Minsky (1972, 1977, 1991) and
Kindleberger (1978), believe that commercial banking is inherently unstable
because banks can and do fuel an euphoria-driven over expansion of credit
(one that is bound to crash) and of money by holding lower ratios of reserves
to deposits than is prudent. When (and if) some of the businesses or projects
to which banks presumably over extended creditfail,banks' assets are reduced
in value and knowledgeable depositors attempt to withdraw their funds (as
described above). Such a run may be contagious, either because many banks
overextended credit at the same time or because depositors cannot or do not

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find it economic to distinguish among economically solvent and insolvent
banks.
Kindleberger (1978) provides copious examples of financial collapses in one
country that appear to have been transmitted to other countries, occasionally
through the collapse of banks. Eichengreen and Portes (1987, pp. 11-12)
suggest an international linkage running from the default of foreign debt to the
failure of banks holding that debt, or depositor withdrawals in anticipation of
a foreign exchange-rate devaluation.

1.1.3. The Relevance of Banking Instability to Countries With Deposit
Insurance Or An Effectively Run Central Bank
A fractional-reserve banking system is not unstable if depositors who
withdraw their funds either redeposit in other banks or purchase safe
securities, such as government obligations, and the sellers deposit the
proceeds in banks. If the funds are redeposited, total bank reserves do not
change, as the receiving banks' reserves are increased to the same extent that
the losing bank's reserves are depleted. As long as banks have approximately
the same voluntary or required ratios of reserves, the money supply is not
affected. Nor is total lending affected, other than some deadweight losses
from a possible reshuffling of bank-customer relationships. This conclusion
holds even ifdepositors shifttheirfunds to foreign banks, as the foreign banks
now have deposits on the original or another domestic bank.
However, some depositors might "run to currency" and keep theirdeposits out
of the banking system in the form of specie (gold and silver) in earlier times
and government-produced currency in later times. Such a run to currency
would reduce the reserves of the banking system, and some banks would be
more likely to fail. Consequently, in the absence of actions by the central
bank, if there were one, there could be a multiple contraction of the money
supply. As Friedman and Schwartz (1963) demonstrate, when prices do not
adjust quickly to the lower quantity of money the result usually is a business
recession or depression. The situation is exacerbated when banks are forced
to call in or forbear from renewing loans so that they can meet the decrease in
deposits from decreases in assets (Bernanke, 1983).
However, central banks could and generally do offset the decrease in bank
reserves with open market operations or direct (discount window) lending to
banks. Thus, even a run to currency need not and should not result in a
banking panic or general economic disaster in modem developed economies.

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Furthermore, credible deposit insurance removes many depositors' incentives
to run to currency, even if the bank were thought to be insolvent. Although
uninsured depositors still have incentives to run, they are very likely to
transfer their deposits to other, presumably safe banks. Almost all of these
depositors with large deposit balances (over $100,000 in the United States)
must use checks or wire transfers rather than currency to pay their bills.
Furthermore, keeping large amounts of funds in specie or currency risks loss
through theft. Lastly, these depositors often have loan relationships with the
bank which are valuable and costly to replicate elsewhere, and their
outstanding bank loans can be used to offset deposit losses. Hence, a run to
currency in the present day in most developed countries appears to be an
unlikely event.
Nevertheless, those concerned with the expansion and sudden contraction of
bank deposits and loans claim that banking is unstable whether or not total
bank reserves or reserve ratios remain the same. These observers believe
that, when demand for bank loans is high, banks shift from secondary
reserves to loans and the central bank makes additional reserves available. In
bad economic periods, even when depositors do not run to currency and even
when the central bank offsets depletions in bank reserves, bank loans decline
as some banks fail and other banks refuse to make or renew loans that appear
to be risky. Thus, these observers believe that the banking system (and,
therefore, also the payments system) is inherently unstable and cannot be
controlled sufficiently well by a central bank to obviate difficulties in the rest
of the economy.

1.2. The Sources of Instability in Fractional Reserve Banking
Itisimportant to distinguish among the sources of presumed past and possible
future instability of the fractional reserve banking system as alternative
explanations imply different public policies. Four alternatives are analyzed:
(1) excessive expansion of bank credit (which calls for controls over bank
lending practices); (2) asymmetric information resulting in the inability of
depositors to value bank assets accurately, particularly when economic
conditions worsen (which calls for greater disclosure, or effective "inside"
monitoring arrangements); (3) shocks originating outside the banking system,
independent of the financial condition of banks, that eithercause depositors to
change their liquidity preferences or cause reductions in bank reserves (which
is no longer relevant for most counties, unless their central banks act
inappropriately, or which necessitates the provision of credible deposit
insurance, either of which offers strong reasons for believing that banking

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panics should not occur); and (4) institutional and legal restrictions that
weaken banks, making them unnecessarily prone to failure (some of these
have been corrected and others can be corrected).

1.2.1. Excessive Expansion of Credit Followed by Forced Liquidation
and Debt Deflation
Fisher (1932, 1933), and contemporary writers, such as Minsky (1972, 1977,
1991) Kindleberger (1978), and Eichengreen and Portes (1987), see financial
crises as emanating from or being exacerbated by over expansion of credit.
Fisher describes business cycles as beginning with an exogenous event, such
as a new invention or discovery, that encourages new investment. Output and
prices increase, which encourages debt-financed additional investment and
speculation in anticipation of capital gains. Banks expand loans by drawing
down reserves, which increases the money supply and raises the price level.
Higher prices both fuel additional optimism and reduce the real value of debt,
thereby further encouraging additional borrowing. Eventually, a state of over
indebtedness isreached, defined by Fisher (1932, p. 9) as "whatever degree of
indebtedness multiplies unduly the chances of becoming insolvent." At this
point, the economy is fragile and a crisis may be triggered by debtors' or
creditors' errors ofjudgment. Debtors may be unable to repay their debts as
scheduled, and creditors may refuse to refinance performing maturing debt.
This leads to distress selling and asset-price deflation. Bank capital is
depleted as bad loans are written off. Depositors run on banks that appear to
be or might become insolvent, creating panics and further price declines, and
reductions in output and employment. The process continues until widespread
bankruptcy eliminates the over-indebtedness or a reflationary monetary policy
isadopted.
Minsky (1972, 1977, 1991) presents a similar description. He posits that a
fragile financial environment isdue to an increase in debt finance, a shiftfrom
long-term to short-term debt, and shifts from debt that can be repaid fully
from cash flows expected from the operation of the assets financed (hedge
debt), to debt where not all the principal can be repaid without selling the
assets (speculative finance), to a situation where additional debt will have to
be obtained to meet expected obligations (Ponzi finance). Financial
institutions' margins of safety are reduced as they finance lower-quality debt.
A loss of confidence or reduced expectations can set off a refinancing crisis,
business failures, runs on banks, bank failures, and economic depression. The
crisis can spread internationally when banks lend internationally.

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Kindleberger (1978) tells the story by means of many anecdotes from
centuries of European and U.S. history. A speculative mania is fueled by
bank money and increasing velocity. As euphoria takes over, interest rates
increase and people shift increasingly from money to goods, resulting in
"overtrading.” Capital inflows from foreign purchases of goods and assets
lead to inflows of specie which fuel monetary expansion and more credit. The
crash comes when enough people realize that the debt cannot be repaid. For a
more recent period ,he concludes (Kindleberger, 1985, p. 28):
The bank failures ... of 1974-86 .. .were brought on by booms
in real estate, farm land, oilexploration and Third World lending
that went to excess before they were cut short by recessions. . .
. The bank failures . . . thus seemed to arise from an historical
pattern of displacement, euphoria, boom in which many bankers
lost sight of conventional and conservative standards of asset
management, and in some cases crossed the line into violations
of the law. The relaxation of standards produced loan and
investment portfolios vulnerable to recession ...
Kindleberger does not necessarily argue that this speculative over- expansion
of bank credit ignites an economic downturn, but that itworsens the problem
that is started by some other force. He describes a few notable bank failures
of the 1930s, from which he concludes that they "fit precisely the MinskyKindleberger hypothesis of credit stretched taut in a positive feedback
process" (Ibid., p. 17).
Minsky and Kindleberger emphasize the role of the lender of last resort in
preventing or mitigating financial collapse. Indeed, Minsky (1991, p. 163-4)
explains why a financial collapse has not happened in recent times as follows:
The combination of lender-of-last resort interventions, which
abort the development of debt-deflation processes, the
generalized increase in liquidity as the Federal Reserve reacts to
an embryonic crisis, and the deficits that big government runs
when income turns down explains why a serious, long-lasting
and deep depression has not taken place up until now. Big
government and a central bank that is willing and able to
intervene explain why ithas not happened yet.
Kindleberger (1978), who is more concerned with internationally transmitted
financial disasters, calls for an international lender-of-last-resort. Guttentag

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and Herring (1987, pp. 173-8) also conclude that an international lender-oflast resort would be desirable. However, they do not suggest creation of a
single world central bank. Rather, they urge that each large bank with
extensive international operations be "adopted" by a central bank, which
would serve as itslender-of-last resort.

1.2.2. Asymmetric Information Resulting in Depositors' Inability to
Value Bank Assets and Banks' Inability to Assess Borrower Quality
Banks specialize in making and holding loans that are not readily marketable,
in large measure because other investors cannot determine the risk posed by
these loans as readily or as cheaply (Diamond, 1984). Banks can utilize
economies of scale and specialization to reduce the transactions cost of
determining the probability that a borrower will not repay a loan as promised,
to monitor the borrower's performance and circumstances, and to take
effective actions to reduce the probability and cost of defaults (Benston and
Smith, 1976). Thus, banks have information about the value of loans that
depositors and other outside investors do not have. This asymmetric
information situation gives rise to a moral hazard that reduces the amount
banks might get should they attempt to sellor securitize theirloans.3
Several financial economists have suggested that bank panics are a
consequence of information asymmetry that makes bank loans difficult for
outsiders to value; when adverse economic events occur, depositors have
reason to question the value of loans. Calomiris and Gorton (1991, p. 125),
for example, give the following summary of this theory: "banking panics are
essentially due to revision of the perceived risk of bank debt in an
environment where there is asymmetric information about bank asset
portfolios."4 Mishkin (1991, p. 74) further explains: "depositors rush to
make withdrawals from solvent as well as insolvent banks since they cannot
distinguish between them." Indeed, some students of banking argue that
many depositors want deposits redeemable on demand at par in order to exert
pressure on bankers to manage their risks appropriately (Calomiris and Kahn,
1991 and Flannery, 1994). They expect to withdraw these funds without loss
ifthey have reason to question the bankers' abilities or probity. This demand
supplements the demand for a medium of exchange.
Thus, banking panics are seen as an inherent source of bank instability that is
tipped off by economic events that are perceived to reduce asset values and
endanger the value of deposits, such as the failure of large or important firms,
unexpectedly large seasonal fluctuations, or major recessions (Gorton, 1988,

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754-5). This theory should be distinguished from the "excessive expansion of
credit" theory, which sees banks as a prime culprits or facilitators rather than
victims of business collapse.
The asymmetric information hypothesis also focuses on the inability of banks
to differentiate among their potential borrowers, particularly in periods of
rising uncertainty and higher interest rates. As a result, banks are likely both
to charge higher quality borrowers higher rates than otherwise, encouraging
them to cut back on their loan demands and reduce their investment projects,
and to reduce lending to all borrowers, thereby reducing spending across-theboard. In this scenario, the banks transmit and possibly amplify disruptions in
financial markets that adversely affecteconomic activity.

1.2.3. Exogenous Deposit and Reserve Withdrawals
Deposit runs may also be started by events that may not be perceived as
reducing bank asset values, such as increased demand for assets that serve as
bank reserves emanating from adverse pressures on exchange rates and the
balance of payments. This would result in ceteris paribus outflows of gold
during a gold-standard period.
Given the necessity of banks' offering
depositors currency and deposits that are redeemable in specie on demand and
at par, an unexpected exogenous withdrawal of specie from a country will
result in a reduction in the banking system's reserves that may cause a
multiple collapse of the money supply and a liquidity crisis. A similar
situation can occur when central banks destroy high powered money through
their open market and other policy operations. Thus, this hypothesis posits
that bank panics could occur before central banks were established (e.g., the
United States in the national banking period) or when they did not neutralize
an exogenous outflow of reserves from the banking system.
In a related but different approach, Diamond and Dybvig (1983) construct a
self-contained model in which changes in some depositors' liquidity
preferences ignite a run by encouraging other depositors to withdraw their
funds rather than suffer losses should the value of the bank’s illiquid assets be
insufficient to repay them in full. Depositors are assumed to redeem their
claims only in the sequence they are received. Thus, a run causes queuing at
the bank, which is observed by other depositors who then increase their
demand for liquidity in order to be more safe than sorry. Diamond and
Dybvig declare: "A bank run in our model is caused by a shift in
expectations, which could depend on almost anything, consistent with the
apparently irrational observed behavior of people running on banks" (Ibid., p.

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404). Such a shift may result from "a random earnings report, a commonly
observed run at some other bank, a negative government forecast, or even
sunspots" (ibid., p. 410). They conclude that a lender of last resort can help
alleviate this situation, but that government deposit insurance is the superior
solution.

1.2.4. Institutional and Legal Restrictions that Weaken Banks
Because of the basic unit banking structure in the United States, banks in the
pre-Federal Reserve years developed and heavily used correspondent banking
arrangements to deal with both expected and unexpected withdrawals of
deposits and demands for loans. In the national banking period (1863-1914),
reserves were concentrated in the New York banks, and legal and cartel
restrictions hindered New York banks from using interest rate adjustments to
retain those deposits during periods of heavy withdrawal demand. At the
same time, the banks were (and still are) restricted from diversifying their
assets and deposits.
Some of the earliest analysts of bank failures (particularly Sprague (1910))
point to restrictions on branching as the cause of the much greater number of
banking panics in the United States than were experienced elsewhere. During
the Great Depression, a common observation was that the United States's
restrictions on branching resulted in thousands of bank failures, in comparison
with Canada’s nationwide branching system, which experienced no bank
closures. However, Canadian banks closed many branches, and there is
reason to believe that, although Canadian banks remained open, many were
economically insolvent (Kryzanowski and Roberts, 1993). Thus, although
branch banking can reduce failures that result from regional collapses, it
cannot insulate a banking system against national or international shocks that
adversely affect the entire economy or the nation's money supply.

2. Empirical Research on the Sources of Bank Failures and Banking
Panics
A number of studies provide evidence on the four hypotheses that attempt to
explain why banking and the payments system are inherently unstable.
These hypotheses are: (2.1) overexpansion of credit by banks and nonbanks
caused banking and economic collapse; (2.2) bank runs, suspensions, and
failures were caused by asymmetric information ;(2.3) exogenous deposit and
reserve withdrawals are responsible for bank failures and banking panics; and

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(2.4) bank runs, suspensions, and failures were caused by governmentinstituted restrictions that weakened banks. Our review of the evidence leads
us to reject the "overexpansion" hypothesis and models based on exogenous
deposit withdrawals. However, we find persuasive the evidence that banks
failed because of exogenous outflows of reserves. The evidence also is
consistent with a version of the asymmetric information hypothesis, and with
the hypothesis that government-instituted regulations weakened banks.

2.1. Overexpansion of Credit by Banks and Nonbanks Caused Banking
and Economic Collapse
There is not much evidence supporting the hypothesis that overexpansion of
credit by both nonbanks and banks caused a banking collapse and then an
economic collapse, although there is some reason to believe that banks fueled
some local unsustainable business expansions (such as the Texas and New
England real-estate booms in the 1980s).5 There is considerable evidence,
though, that business failures often preceded banking panics. Thus, itappears
that banking panics or collapses did not cause economic downturns, although
they did exacerbate them.
Kindleberger (1978) briefly describes (and gives references to in-depth
economic studies) dozens of events that illustrate the overexpansion theory.6
He also presents a table listing thirty-seven financial crises that occurred
between 1720 and 1976. His text and table descriptions appear to support his
thesis. He states that most of the crises were brought under control by an
effective lender of last resort. Unfortunately, he does not distinguish clearly
between financial expansions that were fueled by bank lending from those
driven by increases in base money or by discoveries and inventions. Nor does
he clearly identify crises that were caused or exacerbated by exogenous
changes in the domestic gold supply, by depositor runs on solvent banks, or
those that were due to institutional constraints or fraud. Nor does he contrast
his narrative with examples of important business failures that were not
accompanies by financial crises (with one exception), or bank failures that
were not followed by financial crises or economic contractions. Hence,
although many of his examples seem plausible, they do not appear to support
the case for causal relationships.
Schwartz (1986, 1988) subjects Kindleberger's theory to empirical test. First,
she distinguishes between "real" and "pseudo” financial crises. A real
financial crisis, she says (1986, p. 11), "is fuelled by fears that means of
payment will be unobtainable at any price and, in a fractional-reserve banking

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system, leads to a scramble for high-powered money. . . . The essence of a
financial crisis isthat itisshort-lived, ending with a slackening of the public's
demand for additional currency." A pseudo-financial crisis, on the other hand,
may involve only a loss of wealth as previously glowing expectations are
replaced by uncertainty. "But a loss of wealth is not synonymous with a
financial crisis" (ibid., p. 23). In her 1986 article, Schwartz gives many
examples to illustrate her distinction between real and pseudo crises. In her
1988 article, she catalogues the incidence of banking panics between 1890
and 1929 in seventeen countries. She finds (1988, p. 39) that, "[i]n contrast to
the frequency of bank failures, before 1930 banking panics in which all
depositors attempt to withdraw their deposits in currency were uncommon."
"Bank failures," she reports, "occurred in a variety of circumstances, the
causes including fraud, mismanagement, banking structure, and relative price
change or general price level instability. In some years of bank failures, there
were runs, but no panics. Panics sometimes occurred in conditions of general
price level instability, but most countries had learned by the end of the
nineteenth century what actions were necessary to avert panics" (Ibid., pp. 3536). She concludes : "Clearly, bank failures do not betoken either runs or the
onset of panics" (ibid.,p. 40).
Schwartz (1988) argues that those, such as Kindleberger, who hypothesize
that banks are inherently unstable because economic agents inherently act in
unstable ways, fail to recognize the detrimental effect on banks of unexpected
changes in price levels and of dysfunctional incentives faced by bank
managers. She points out that banks' risk profiles and the stability of the
banking system would be enhanced by greater macro price-level stability and
by a policy of resolving bank failures before theircapital turned negative.
Cagan (1965) analyzed the role of banking panics in his study of the
determinants of the U.S. money supply. He associates panics with the prior
failure of prominent financial institutions or railroads. However, he also finds
that panics all followed peaks in economic activity, from which he concludes
that they did not precipitate economic downturns. However, he finds that
panics were important in reducing money supply growth, which converted
mild contractions into severe contractions. But, because two severe economic
downturns (1920-21 and 1937-38) and two mild downturns (1890 and 1914)
were not associated with banking panics, Cagan concludes that panics were
neither necessary nor sufficientfor such downturns to occur.
Bordo (1986) examines evidence from six countries the United States, Great
Britain, France, Germany, Sweden, and Canada on the relationship between

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the incidence of financial panics and declines in economic activity that might
have resulted from overexpansion and monetary contraction. Over the period
1870-1933 in the countries studied, Bordo finds: "First, severe declines in
economic activity in all countries are associated with (prior) declines in
monetary growth. Second, most severe cyclical contractions in all the
countries examined are associated with stock market crashes, but not, with the
exception of the US, with banking crises" (ibid.,pp. 229-230).7
Finally, Eichengreen and Portes (1987) compare international financial crises
in the 1930s with those in the 1980s. They are particularly interested in
describing "the singular importance of linkages running from debt defaults
and exchange market disturbances to the instability of banking systems"
(ibid., p. 18). In the prior decades, they say "foreign lending was associated
with expanding trade and rosy prospects at leastin the short run" (ibid., p. 15).
They find that "[m]acroeconomic events, rather than disturbances limited to
financial markets, played a leading role in the onset of the debt crisis" of the
1930s (ibid., p. 21). The defaults did not greatly affect foreign banks, as the
debts were a relatively small proportion of their assets. However, domestic
banks, which held proportionately more of the debt of the same borrowers,
were more severely hurt. Furthermore, Eichengreen and Portes conclude that
"shocks with the potential to destabilize the banking system did not lead to
generalized collapse because central banks acted in lender-of-last resort
capacity and simply did not permit this to happen" (ibid., p 26). The same,
they state, cannot be said for the United States. (Kindleberger, 1978, and
Minsky, 1991, reach a similar conclusion.)
Eichengreen and Portes (1987) describe the 1980s as characterized by a
"density of international interbank relationships [that] now is incomparably
greater [than the earlier period]" (ibid., p. 33). Exchange rates have exhibited
unexpectedly high volatility without (surprisingly, they say) exchange-market
collapse or any overall drift towards controls (ibid., p. 36). Foreign debt
exposure has grown. But there have been no serious financial crises.
Eichengreen and Portes conclude: "The main dangers lie not in disturbances
originating in financial markets but in malfunctions of the real economy"
(ibid., p. 50).

2.2. Bank Runs, Suspensions, and Failures Were Caused by Asymmetric
Information
Studies testing the asymmetric information hypothesis provide evidence
supporting the version that posits that bank failures and panics are caused by

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business failures, rather than the reverse. Presumably, because it is difficult
for depositors to value banks' assets, depositors run on banks because their
experience with business collapse causes them to believe that banks also may
also be insolvent. However, the studies do not distinguish between bank
failures caused by actual reductions in the value of banks' assets and failures
caused by runs on solvent banks that were perceived to be insolvent.
Calomiris and Gorton (1991) tested the asymmetric-information and the
random-withdrawal hypotheses with data from the national banking period.
They examined measures of bank liquidity (reserve ratios and changes in
deposits) in the weeks before the six episodes that they identify as banking
panics because clearing-house certificates were issued or authorized: 1873,
1884, 1890, 1893, 1896, and 1907. They also examine the data for unusually
large seasonal shocks and business failures. Adverse general economic
conditions are measured by unusually large changes in stock prices. They
find that the data "do not support the notion that panics were preceded by
unusually large seasonal shocks or that panics resulted from tripping a
threshold of bank liquidity" (ibid., p. 133). They also find that "the timing of
panics (with the possible exception of the Panic of 1873) places them after
weeks of seasonal shocks associated with planting and harvesting" (ibid., p
138, emphasis in original). Thus, they reject the agricultural seasonal
explanation for panics.
However, Calomiris and Gorton (1991) find that unusually adverse movement
in stock prices characterized the pre-panic periods. "[Ljarge withdrawals [by
country banks from New York banks]", they state, "only threatened the
banking system when they were accompanied by (perhaps precipitated by)
real disturbances" (ibid., p. 143). They find that "panics are associated with a
threshold level of news receipt concerning the growth of liabilities of failed
businesses, which is a leading indicator of recession" (ibid., p. 148). Because
the news receipt induces a sudden but rational downgrading by depositors of
the financial health of their banks, Calomiris and Gorton conclude that the
asymmetrical-information theory of banking panics is supported.
In addition, they examine analyses published in the annual reports of the
Comptroller of the Currency of the causes of the 116 bank failures that
occurred in the roughly six months around the panics. They report: "in the
overwhelming majority of cases (91 of the 116), failure was not attributed to
panic-induced stringency in the money market. Furthermore, the fact that the
Comptroller only attributed one failure to a bank run per se shows that the
direct link between bank runs and bank failures during panics was not

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important" (ibid., p. 154, emphasis in original). In addition, they find a
regional pattern offailures that is "incompatible with the withdrawal risk view
of panics" (ibid.,p. 158).
Calomiris and Gorton's (1991) findings, based on tables of data, confirms
Gorton's (1988) earlier econometrically based study. Gorton examined the
variables associated with the deposit/currency ratio in periods characterized
and not characterized by banking panics during the national banking period.
Using quarterly call-date data, he finds that changes in business conditions
and risk (proxied by the liabilitiesof failed businesses and changes in pig iron
production) peak at the same time as banking panics, and concludes that
"panics seem to have resulted from changes in perceived risk predictable on
the basis of prior information" (ibid., p. 778). Furthermore, he finds that the
equations fitted with data from the nonpanic periods explain the panic periods
well. He also analyses the banking panics of 1930, 1931, and 1933, and finds
that they occurred well after the business cycle peak. His analysis causes him
to
reject the
Diamond/Dybvig
"depositor
instability"
and
Minsky/Kindleberger "loan contraction" theories: "the mechanism of
causality running from depositors withdrawing currency from 'illiquid' banks
and causing businesses to fail isnot present, at leastwhen all [panic] dates are
examined. Second, the response of banks to panics was not to liquidate loans,
but to issue circulating private money which insured depositors against the
failures of individual banks" (ibid.,pp. 778-779).
Donaldson (1992) uses weekly data from 1867 through 1933 to test Gorton's
(1988) finding thatpanics and nonpanics are generated by similar responses to
changing perceptions of deposit risk, and the inference thatchanged economic
conditions caused banking panics, rather than the reverse. Donaldson uses the
(brokers’) call-loan interest rate as the dependent variable.8 Using a dummy
variable structure to measure the effect of panics, he finds that, while call-loan
interest rates increase generally when bank reserves and deposits decrease,
there is a larger-than-normal increase during bank panics. Also, a stockmarket index variable is not significantly related to call-loan interest rates in
nonpanic weeks, but is significantly negatively related in panic weeks lower
stock prices are associated with higher interest rates during panics. Thus,
Donaldson's shorter-period weekly data reveal that brokers' call-loan interest
rates are higher during panics, but that the relationship between panics and
interest rates is played out within a quarter. We believe that his findings are
consistent with Gorton's view that negative economic events as measured by
stock prices caused or are associated with banking panics.

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Mishkin (1991) examined banking panics over the period 1857 through 1988,
primarily by charting stock prices and the spread between high-grade
commercial paper and brokers' call loans monthly in periods around banking
and financial panics. He also gives a narrative discussion of each panic,
pointing out the specific business failures that preceded the panics. He finds
(ibid.,p. 96) that:
1. with one exception in 1873, financial panics always occurred
after the onset of recession;
2. with the same exception in 1873, stock prices declined and the
spread between interest rates on low- and high-quality bonds
rose before the onset of the panic;
3. many panics seem to have features of a liquidity crisis in
which there are substantial increases in interest rates before the
panic;
4. the onset of many panics followed a major failure of a
financial institution, not necessarily a bank. Furthermore, this
failure was often the result of financial difficulties experienced
by a nonfinancial corporation;
5. the rise in the interest spread associated with a panic was
typically soon followed by a decline . . . [followed, in 1873,
1907, and the Great Depression, by an increase] when there was
deflation and a severe recession;
6. the most severe financial crises were associated with severe
economic contractions ...;
7. although stock market crashes often appear to be a major
factor in creating a financial crisis, this was not always the case.
Mishkin (1991, p. 97) concludes that his findings are consistent with the
asymmetric-information theory: "Rather than starting with bank panics, most
of the financial crises began with a rise in interest rates, a stock market
decline, and the widening of the interest rate spread." He rejects the depositwithdrawal theory of financial panics because itcannot explain why banking
panics occurred when they did (ibid., p. 97).9

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Park (1991) discusses the panics of 1873, 1884, 1893, and 1907 and the
nationwide bank holiday in 1933. From his narrative descriptions, he
concludes that "[liquidity risk . . .does not by itselfinvite systemwide bank
runs. The other necessary ingredient is a lack of bank-specific information on
solvency” (ibid., p. 285). He does, though, consider exogenous reductions in
bank reserves as a causal factor.10

2.3. Exogenous Depositand Reserve Withdrawals
Several studies provide strong evidence leading to the conclusion that
exogenous outflows of bank reserves (primarily gold before 1934) that were
not attributable to actual or perceived weaknesses in bank asset values
resulted in shortages of liquidity and banking panics. This situation affected
primarily the United States, as itdid not have an effective lender of lastresort.
The findings reviewed are consistent with the hypothesis that banking panics
are due to actions or inactions of central banks, rather than to an inherent
instability of banking.
As noted, Donaldson (1992) examined the relationship between call-loan
interest rates, bank reserves, deposits, stock-market prices, and banking panics
from 1914 (after the creation of the Federal Reserve) through 1934. He finds
higher interest rates associated with panics but not with the other variables.
Miron (1986) found that the Federal Reserve was able to reduce the
magnitude of seasonal interest rate changes, compared to the national banking
period before it was established. However, he also found "that the Fed
accommodated the seasonal demand in financial markets to a lesser extent
during the 1929-33 period than it had previously. This means that the
frequency of the panics should have increased, as it did." (Ibid., p. 136,
emphasis in original.) Donaldson (1992) conducted further tests showing that
banking panics are characterized by the inability of the money supply to
expand rapidly during economic crises. Even though panics may be "special
events," he concludes that "panics can be stopped by allowing banks to turn
nonliquid assets into cash by printing new banknotes during times of crisis"
(ibid., p. 295). These findings are consistent with the hypothesis that
exogenous outflows of bank reserves or gold, or ineffective actions by the
central bank cause banking panics. (They also are consistent with the
asymmetric-information hypothesis.)
Donaldson (1992) confirms Gorton's (1988) finding that the panic of 1933
would have been more serious had the Fed not (belatedly) injected new
money in that year. Donaldson also reports that gold reserves at the Fed fell

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prior to the onset of the panic, which he notes, supports Wigmore's (1987)
hypotheses that the March 1933 bank holiday was caused by reductions in the
money supply as people hoarded gold in anticipation of the devaluation of the
dollar.
As noted above, Cagan (1965) and Bordo (1986, 1992) find that banking
panics and economic downturns are associated with declines in the monetary
gold stock and high-powered money. Huffman and Lothian (1984) examine
the international transmission of economic fluctuations under the pre-1933
gold standard. They find that, between 1830 and 1934, gold outflows played
the most important role in reducing the domestic money stock in both the
United States and Great Britain. Furthermore, because they find banking
panics in but three of twelve common cycles, they conclude that panics have
little importance as a means by which economic fluctuations are transmitted
internationally.
Tallman and Moen (1994) investigate whether exogenous outflows of the gold
stock were key in starting a banking panic during the national banking period.
At that time, gold comprised the principal portion of banks' reserves that
actually changed. They describe the causes of gold outflows from the United
States, such as the Bank of England's raising the discount rate from 2.5 to 6.0
percent in 1882 and the European central banks raising theirdiscount rates in
1890. The United States did not have a central bank that could neutralized
these actions with offsetting increases in discount rates. Using statistical
techniques, Tallman and Moen distinguish between expected and unexpected
gold flows. They find that panics are due primarily to unexpected exogenous
gold shocks (outflows). These outflows preceded stock market declines,
interest-rate increases (spikes), and output contractions.
Wigmore (1987) provides strong evidence indicating that the banking panic of
1933 was caused by a run on the dollar, rather than a loss of confidence in the
solvency of banks. The run was precipitated by indications that President
Roosevelt would devalue the dollar once he took office (which, at the time,
was not until March 4th). The prospect of substantial returns from holding
gold resulted in a drain of gold from commercial banks and the Federal
Reserve banks, particularly the Federal Reserve Bank of New York. Closing
all banks until the reserves could be replaced (as gold was purchased by the
Treasury at $35 an ounce, compared to its previous market price of $21 an
ounce), as Roosevelt did in the Bank Holiday of March 1933, was an effective
way to deal with this government-caused crisis.

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Much of the academic criticism of the Diamond/Dybvig (1983) model has
been concerned with the restrictiveness of their assumptions. Calomiris and
Gorton (1991) present an excellent review of much of this literature.11 Some
of these articles point out that panics would not occur ifdepositors' demands
did not have to be met sequentially. Others argue that the implications would
be different if allowance was made for multiple banks rather than a single
bank and the banks could take cooperative protective actions against runs.
"Thus," Calomiris and Gorton (1991, p. 123) point out, "panics were not
inherent to banking, but were linked to a particular institutional structure,
namely, unit banking and reserve pyramiding." Nevertheless, Diamond and
Dybvig's model predicts that banking panics would occur atrandom times and
in a wide variety of institutional arrangements. Hence, its basic prediction
appears to be contradicted by even a casual examination of the data.
Furthermore, by assuming a monopoly bank, Diamond and Dybvig
automatically assume that a run on one bank is equivalent to a run on the
banking system and do not take account of the protective arrangements banks
might make in a multiple bank system. These include cooperative actions,
such as correspondent banking arrangements and clearing house agreements,
to mitigate bank runs.12 At the same time, Diamond and Dybvig cannot take
account of competitive actions by banks in a multiple bank system to assure
depositors that they have, or can get, the funds depositors might demand.
They also take no account of actions by central banks to maintain bank
reserves should depositors remove their funds from the banking system (or
from the monopoly bank) and keep the funds in currency or specie.
Calomiris and Gorton (1991) subjected the "random depositor-withdrawal"
hypothesis to rigorous tests using data from the U.S. national banking period.
These tests provide no support for the hypothesis thatdepositor instability was
a cause of banking runs, suspensions or failures. Furthermore, Schwartz's
(1988) finding that banking panics were unusual events (except in the United
States) is inconsistent with the random depositor-withdrawal hypothesis.
Hence, we conclude that the policy implications of the Diamond and Dybvig
model are not very useful for understanding the workings of the extant
banking and payments system.

2.4. Bank Runs, Suspensions, and Failures Were Caused by Legally
Instituted Restrictions thatWeaken Banks
Many empirical studies (including those discussed above) indicate that the
United States experienced bank panics in large measure because of the

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weaknesses of the national banking system and restrictions on branching.
These findings are important, because they provide reason to believe that
banking panics can be reduced in frequency, if not avoided altogether, by a
banking system that permits diversification through branching and in which
bank reserves are controlled appropriately by a central bank.
Sprague (1910) analyzes five of the six U.S. banking panics in the national
bank period associated with serious economic downturns 1873, 1884, 1890,
1893, and 1907. (The sixth occurred in 1914.) He notes that the panics
occurred in either spring or fall, and that they usually were preceded by the
failure of a large business or financial firm. The seasonal movement of funds
between agricultural areas and financial centers put strains on banks' reserve
positions, making them vulnerable to an unexpected shock, such as the failure
of an important firm or an unexpectedly large harvest or a natural disaster.
Without a central bank to replenish reserves, some banks had to suspend the
convertibility of bank notes to specie as note holders and depositors attempted
to run to what they saw as "good" money, and some banks failed.
Smith's (1991, p. 233) narrative description of banking panics during the
national banking period indicates that "panic related withdrawal demands (on
New York banks) came heavily from interior [country] correspondent banks.
And restrictions on payments by New York (and other money center) banks
fell much more heavily on correspondent banks than on non-bank depositors."
This finding is consistent with the hypothesis that institutional and legal
constraints caused or exacerbated banking panics.
Bordo (1986) finds that monetary contractions associated with financial
contractions were more severe in the United States than in the other five
countries he studied. "One explanation," he says, "is the greater instability,
compared to that of the five other countries, of the US banking system a
system composed largely of unit fractional reserve banks with reserves
pyramided in the New York money market. ... In contrast with the U.S.
experience, the five other countries in the same period all developed
nationwide branch banking systems consolidated into a few very large banks"
(ibid., p. 230). (His second reason isthe absence of an effective lender of last
resort.)

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2.5 Conclusions from the Empirical Research on the Sources ofBank
Failures and Banking Panics
The empirical research reviewed leads us to reject the hypotheses that bank
panics have been caused by or related to over-expansion by banks and
nonbanks or to random runs by depositors. The evidence is consistent with
the strand of the asymmetric-information hypothesis which posits that
depositors tend to run on banks when adverse economic conditions (such as a
stock market crash or the failure of well-known, important companies) leads
them to doubt the value of banks' assets, although the evidence does not
distinguish between runs on insolvent and solvent banks. The evidence does
support the hypothesis that banks were rendered more likely to fail when
adverse shocks were experienced because of existing government restrictions
on their ability to diversify risks and institutional weaknesses of the U.S.
national banking system. We find persuasive the data supporting the
hypothesis that bank panics were caused by liquidity crises that were the
result of exogenous withdrawals of bank reserves. These withdrawals took
the form of exports of specie and depositors' runs to specie and currency.
These reserve depletions can be offset by actions taken by the central bank.
Hence, we conclude that the private banking and payments systems are not
inherently unstable.
Central bankers (and others), though, often express fears that runs on banks
could be contagious, spreading before the central bankers can take effective
measures to neutralize reserve withdrawals. Furthermore, they are concerned
that contagious bank panics could result in the failure of many banks, thereby
reducing the supply of bank credit in some areas and causing considerable
economic distress. Hence, we turn now to evidence on contagious runs on
banks.

3. Contagion o f Bank Runs, Suspensions, and Failures
Runs on banks have been a subject of fascination by finance professionals,
regulators, the press, and the general public for many years. Runs, like all
financial panics and doomsday scenarios, make "good press," in part because
banking is not well understood and thus any perceived breakdown is
frightening to the public. One of us has reviewed thoroughly the literature on
bank runs in a recent article (Kaufman, 1994A). The empirical evidence on
bank runs is clear; except for speed, runs on banks that lead creditors to
withdraw their funding are not much different than customer and creditor

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responses to other industries' products that are perceived to be dangerous, e.g.,
contaminated soft drinks or medication, airplane crashes, and nuclear power
plant accidents. The evidence suggests clearly that depositors run on
particular banks for specific, well-documented reasons (e.g., large losses on
LDC and real-estate loans relative to a bank's capital or fraud), and they run
on other banks that appear to have similar problems because of similarities in
their balance sheets, borrower characteristics, or market areas. However,
depositors do not run on banks that are not so perceived. That is, runs are
bank-specific and information based, not industry-wide and rumor based.
This is true even in the few periods in U.S. history in which there were serious
runs to currency because depositors doubted the solvency of many banks, 13
e.g., 1893 and 1929-1933 (Calomiris and Mason, 1994).
Moreover, the evidence shows that runs were not a major cause of bank
failures. Runs may have caused liquidity problems, but the "fire-sale" losses
were rarely great enough to render a bank insolvent. Rather, solvency
problems caused by other factors led to runs that caused liquidity problems
that worsened a bank’s solvency problems. Thus, depositors appear capable of
differentiating between solvent and insolvent banks, just as they can
differentiate between tampered and untampered drug and soft drink products,
and dangerous and safer modes of transportation.
The evidence suggests that bank runs and failures rarely conform to the
process described in many academic models. Runs are initially ignited by
specific, observable events affecting special banks rather than an exogenous
shift in depositor liquidity preferences affecting all banks. Solvent banks
experiencing sudden deposit withdrawals can sell assets to or borrow funds
quickly from other banks to restore their deposit losses at reasonably low cost.
Only banks known to other banks to be insolvent or nearly so would
experience difficulties in recycling funds and face closure. Consequently, the
likelihood of runs on most or all banks, which is a prerequisite for a run to
currency, is small. Except for fraud, bank insolvencies are not sudden nor
occur overnight. As discussed earlier, this casts doubt on the usefulness of
models that assume only one bank so that a run on a bank and on the banking
system are one and the same, such as the model constructed by Diamond and
Dybvig (1983).
Even if there were a run to currency, the potential damage could be avoided if
the central bank offset the reserve drain from banks by increasing its reserve
provision through open market operations or discount window lending by
amounts equal to the reserve loss. In the absence of central banks, banks

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typically undertook cooperative actions through clearing house associations
that limited reserve losses through temporary suspensions of convertibility, in
early days of bank notes for specie and in later days of deposits for currency.
Clearinghouses also issued loan certificates that banks used to clear checks,
thereby allowing them to operate with lower levels of reserves (Dwyer and
Gilbert, 1989, and Tallman, 1988). Thus, as documented by Schwartz (1988),
except in the United States, banking panics caused by bank runs have been
rare in the last century.

4. Costs o f Bank Failures, Runs, and Panics
The consequences of a bank failure and a banking panic can be severe. First
(in section 4.1), we consider the cost of the failure of or run on a single bank
and then (in section 4.2) the cost of the failure of several banks. In section
4.3, we discuss the risks to the payments system of bank failures and panics.
Because derivatives have come into increasing use recently and are potentially
a source of large losses, we consider the risks associated with these financial
instruments in section 4.4.

4.1. The Cost of the Failure of a Single Bank
Bank customers (particularly borrowers) who made investments in bankspecific information and for whom making alternative arrangements are
costly, might be hurt should their bank fail or have to reduce the extent or
scope of its operations as a result of a run. However, it is important to note
that other banks offer very similar services and products, and most bank
customers have accounts with more than one bank. 14 Furthermore, other
firms offer close substitutes to almost all of the products and services offered
by banks.
Many nonbank financial companies make loans, including
installment loans made by consumer and sales finance companies, mortgages
by mortgage bankers, and commercial loans by nonbank lenders such as
General Electric Capital Corporation, and loans in the form of accounts
receivable by many companies. Checking is the only important possible
exception, and this service is offered, to a limited extent, by brokerage houses
and money market mutual funds, who let their customers use their bank
accounts.
These other financial institutions also offer employment
opportunities for the employees of a closed bank. Nevertheless, some private
information known only to the bank providing the loan or other financial
service may be costly to transfer quickly and some bank customers are likely
to suffer transition costs.

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Stockholders, depositors with partially uninsured balances, nondeposit
creditors, and perhaps some senior bank managers and other employees at a
failed bank might suffer losses. But, this possibility provides an important
incentive for these parties to take actions that would avoid or mitigate losses.
Moreover, except when liquidated, failed banks do not disappear. As long as
there is an unmet demand for banking services in the service area, failed
banks usually are acquired by or merged with an existing bank or sold to new
owners. Thus, most employees are likely to keep their jobs, although not
perhaps their exact positions.
Losses to uninsured depositors and other creditors depend on the magnitude of
the bank's economic negative net worth when the bank is resolved. This, in
turn, depends on how quickly a bank is resolved after its net worth is fully
depleted. If it is resolved before that time, as is contemplated by the
structured early intervention and resolution provision of the FDIC
Improvement Act of 1991, little if any losses would accrue to these claimants.
Should there be runs on solvent banks that are incorrectly thought to be
insolvent (perhaps because apparently similar banks failed), "innocent" bank
owners, nondeposit creditors, and senior managers might be hurt. But, the
possibility of such runs can be negated by actions taken by banks to convince
depositors that their funds are safe. Such actions include holding sufficient
capital to absorb possible losses and disclosure of information about the
bank's operations to obviate misperceptions. Moreover, even if such runs
occur, bankers also can (and do) establish cooperative ventures, such as
correspondent
relationships,
mutual
insurance
associations,
and
clearinghouses, to stop or reduce substantially the cost of the run. As Gorton
(1985) and Gorton and Mullineaux (1987) show, these cooperative
relationships were effective in mitigating the effect of banking panics on
solvent banks.
Legal restrictions on branching, though, can hamper insolvent or weak banks
from being acquired by other solvent banks. Even when banks can branch
without restriction, laws that prohibit non-banking firms from owning banks
also reduce the set of potential purchasers of weak banks. Such laws also
restrict banks from diversifying optimally and from achieving economies of
scope, and tend to protect ineffective bank managers from the discipline of the
market for corporate control. Thus, the probability and costs of individual
bank failure are increased as a result of restrictive laws.

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The costs of a bank failure to stakeholders other than stockholders might be
compared to the costs of the failure of other firms as an aid to assessing the
relative importance of bank failures. As Horvitz (1965) observes: "The
failure of the textile mill in the one-mill New England town is almost
certainly a greater community disaster than the failure of the local bank in a
one-bank town." The failure of a manufacturer of special purpose or unique
equipment (such as milling machines and computers) would be costly to
owners of that equipment who need parts and service, and to employees who
had product-specific skills. In contrast, banks produce standardized products,
such as checking accounts, and individualized products, such as loans, for
which there are many close substitutes and alternative suppliers. Thus, there
is reason to believe that bank failures are less disruptive than are business
failures generally.
Benefits from bank failures and runs also should be considered. As noted
above, the possibility or threat of runs gives bank managers and owners
incentives to manage their banks prudently so that they can avoid and survive
any run. The potential failure of banks, as with other firms, is desirable for an
economic system to achieve efficiency. Actual failure also is an almost
inevitable and necessary outcome of beneficial risk taking. 15
Consequently, we conclude that there are relatively few direct costs and
almost no costly externalities from individual bank failures, and there can be
substantial benefits. On balance, then, individual bank failures, as such,
should not be prevented. They are not a source of instability in the banking
and, hence, of instability in the payments system.

4.2. The Failure of Several Banks
Bank failures are widely perceived as more harmful than the failure of other
types of firms, particularly nonfinancial firms, because they are believed to
occur faster, spread more broadly throughout the industry, result in larger
numbers of failures of similar firms, impose larger losses on creditors
(depositors), and are more likely to affect other sectors of the economy and
the macroeconomy as a whole. The evidence on each of these reasons is
summarized next. 16
Because deposits, particularly demand deposits, can be removed faster from a
bank than maturity debt from other financial and nonbank firms, and faster
than reductions in sales can drive firms into insolvency, the "greater speed"
hypothesis is true, almost by definition. However, faster failures are not

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necessary more harmful failures. Indeed, if a firm has failed because of poor
management, its creditors generally benefit from its expeditious closure. Ex
ante, bank managers' concerns about runs by depositors serve to motivate the
managers to operate their banks so that depositors do not perceive the need to
run.17
Bank failures are believed to affect other banks more broadly than the failures
of nonbanks affect other firms in the industry, both because depositors are
assumed to be less able to differentiate the products or financial health of
banks than of other firms, and because banks are directly connected through
interbank balances (particularly in the United States, where branching is
limited), so that the failure of one bank may impose losses on other banks.
But, as noted in section 3, the evidence is overwhelming that failures and runs
have been bank specific and that depositors have been able, at the margin, to
differentiate between good and bad banks both before and after the
introduction of the FDIC in 1934. Even anecdotal descriptions focus on a few
institutions during panics, although most intermediaries faced large
withdrawals. Moreover, the fact that banks have credit relationships with
each other does not imply that they do not act to protect themselves from this
exposure. For example, although the Continental Illinois Bank had deposit or
Fed funds relationships with over 2,000 banks at the time of its failure in
1984, its failure did not directly cause the failure of any other bank. Indeed,
had Continental's creditors not been protected by the FDIC, only two
Continental-related banks would have suffered losses as large as fifty percent
of their capital when Continental failed (Staff Report, 1991).
Although bank failures generally receive greater attention than other failures,
the average annual rate of bank failures has been about the same as for
nonfinancial firms. This is true even before the introduction of federal deposit
insurance, particularly before the establishment of the Federal Reserve in
1913, when the average rate of bank failures was actually lower than that of
nonbanks. But the annual variability rate for bank failures has been greater.
To a considerable extent, the relatively high failure rate for banks in the
United States reflects their inability to reduce their risks effectively by freely
diversifying geographically or product-wise because of legally imposed
restrictions (White, 1983 and Benston, 1990).
Similarly, although depositors are widely perceived to experience substantial
losses in bank failures, the evidence suggests that their losses have been
considerably smaller on average than those suffered by bondholders and other
creditors in the bankruptcy of nonbanks (Kaufman, 1994A). The actuality is

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due, primarily, to the faster bank resolution process, even in the 1930s and
1980s, than the bankruptcy process applied to nonbank firms. These lower
resolution costs help explain the substantially lower capital ratios maintained
by banks relative to nonbanking firms, both before and after the establishment
of the FDIC.
Lastly, bank runs and failures are perceived to spill over beyond the banking
sector to other financial sectors and the macroeconomy, primarily through
runs into currency that result in a reduction in money aggregate and bank
credit and through abrupt reductions in lending. But, as already discussed,
with only rare exceptions, large-scale bank failures occurred after downturns
in the national economy, not before. Thus, the stronger direction of causation
appears to run from the real economy to banking, rather than the other way
around. Loans that turned bad from bad economic conditions cause bank
failures, rather than bad loans from over-expansion in a healthy economy
cause bank failures and a turnabout in the economy.

4.3 Risks toThe Payments System
As noted earlier, bank failures are viewed particularly adversely because
banks' major liabilities (demand deposits) serve as the major part of the
money supply and, at least in the United States, banks operate the interbank
funds clearing system. An efficient payments system, in which transferability
of claims is effected in full and on time, is a prerequisite for an efficient
macroeconomy. Similarly, disruptions in the payments system result in
disruptions in aggregate economic activity. To some observers, instability in
the payments system is more threatening than instability in deposits. This fear
appears to refect the larger dollar volume of daily payments, the speedy
movement of the funds, and unfamiliarity with the clearing process.
For an individual bank, the large volume of settlements nets out within a day.
Checks and other interbank transfers through clearing houses (including the
Federal Reserve) are not necessarily received and paid simultaneously during
a day. Rather, within the day, banks frequently pay large claims on
themselves (such as securities purchases by customers) before receiving
payment from the customer. Such "daylight" overdrafts usually are settled at
the close of the business day. A potential for default exists if the expected
payments to the bank do not materialize in full and on a timely basis.
Consequently, the paying bank may be unable to pay the receiving bank. In
such a scenario, the previous payments need to be reversed or unwound. This
may be complex and time consuming and cause "gridlock" in the payments

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system that interrupts the smooth flow of trade. Moreover, if the losses to the
paying bank from customer defaults were large enough to drive it into
insolvency, the receiving banks would experience losses, which might be
sufficient to drive them to insolvency if these losses exceed their capital.
But, these interruptions and losses occur because payment is not in "good
funds" and daylight overdrafts are not priced correctly and, until recently in
the United States, not priced at all if the transfers were conducted on the
Federal Reserve's Fedwire. Indeed, to the extent the Federal Reserve
guaranteed final payment on Fedwire, any losses would accrue to the Fed
rather than to banks and daylight overdrafts would be implicitly encouraged.
Thus, the existence of substantial amounts of daylight overdrafts on Fedwire
reflects poor regulation, not an inherent weakness in the system (Flannery,
1988, Gilbert, 1989, and Eisenbeis, 1995). Without a government-provided
guarantee, overdrafts are a credit-risk problem, basically similar to the creditrisk problems banks incur in their daily lending activities which they have
learned to evaluate, monitor, and charge for.

4.4 Banks' Activities in Derivative Financial Instruments
Recently, attention has shifted to potential instability from the activities of
banks and others in derivatives. Much of this concern is due to the
observation that the notional value of these instruments is much larger than
either that of deposits or the payments system, that transactions and payments
occur quickly, and that the design of some of these instruments is highly
complex, causing them to be mysterious to and misunderstood by many.
Although most of the risks are credit- and interest-rate risks that are similar to
those on other securities, some other risks may be greater, as the institutional
framework is newer, probably less efficient, and not yet thoroughly tested by
experience. These risks include settlement, operational (control systems),
valuation (pricing), and legal (netting and bankruptcy) (GAO, 1994).
Nevertheless, there appears to be no evidence that derivatives involve any
greater threat to the stability of banking or the payments systems than do
deposits or loans
which is to say, no threat if banks maintain sufficient
capital (as required by the market) and if the central bank acts effectively as a
lender of last resort to keep the money supply from contracting.
Furthermore, there is reason to believe that derivatives are used primarily to
reduce risks to banks and their clients. Interest-rate futures, forwards, swaps,
and options are effective for reducing duration gaps at banks that fund long­
term assets with short-term liabilities. Foreign currency futures, forwards,

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swaps, and options can hedge the risks banks undertake in providing services
to their customers. Those customers also benefit from banks’ services in
arranging interest-rate swaps and in making a market for financial derivatives.
Over-regulation that prevents optimal use of derivatives to reduce risk,
therefore, might increase the risk and cost of bank failures, and increase costs
to banks' customers. Losses from unwise use of derivatives, like losses from
unwise use of other assets, may be kept from damaging the banking system by
having banks maintain sufficient capital to absorb possible losses and by
resolving insolvencies in a timely manner. Excessive regulation may also
prevent end-users from hedging adequately. Losses and even failure of
nonbank dealers or end-users is of little public policy concern. Failure of
banks that use derivatives is of greater concern due to the government's
provision of deposit insurance. But, the dangers of large losses and contagion
is reduced by the system of prompt corrective action and least-cost resolution
of seriously undercapitalized banks, as described in section 6.

5. Lender o f Last Resort
5.1 Domestic Lender of Last Resort
As argued above, bank panics or runs to currency should not cause bank
failures in economies with central banks if the central bank performs its duties
as lender of last resort to restore reserves lost to currency drains. The bank
may do so either through its discount window or through open market
operations. Discount window assistance has been the traditional technique
used by central banks, particularly in economies in which the financial
markets were not fully developed and able to transfer funds from surplus to
deficit areas quickly and cheaply. In theory, banks experiencing runs could
borrow from the central bank, which would lend to them as long as they
believed the institution to be solvent. That is, the central bank provided
liquidity assistance, not solvency assistance. To discourage banks from
making unjustified use of such support, Bagehot (1873), Meltzer (1986),
Schwartz (1992), and others recommended that the support be made available
only at a penalty interest rate.
But recent evidence, at least in the United
States, suggests that the Federal Reserve did not provide such support only at
penalty rates or only to illiquid but solvent institutions (Kaufman, 1991). As a
result, many banks received liquidity support at subsidized rates. A study by
the House Banking Committee reported that 90 percent of the more than 400
banks that received extended credit from the Federal Reserve discount
window in recent years subsequently failed. (U.S. House of Representatives,

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1991.) It is doubtful whether most or any of the banks, including large banks
such as the Continental Illinois, New England National, M Corp, and First
Republic, were solvent at the time they received assistance. Although the
Federal Reserve may have better information about the financial condition of
banks experiencing liquidity problems than the market and other banks, past
experience does not indicate that it can use this information to restrict its
lending only to solvent institutions. The Fed can lend to insolvent institutions
with little concern, as it requires all loans to be fully collateralized. Losses
from bank insolvency are borne by others uninsured depositors, creditors,
and the FDIC.18 To the extent that Fed discount-window lending to insolvent
or near-insolvent banks resulted in their generating larger losses than
otherwise, the cost of these failures to the ultimate bearers of the losses was
increased.
In an economy with a well developed financial market, the central bank need
not determine the correct interest rate that it should charge or have to
differentiate between solvent and insolvent illiquid banks. The bank could
provide liquidity support only through open market operations, and permit the
market to allocate the funds to individual banks. Market participants, whose
own funds are at risk, are more likely to distinguish between banks
experiencing only liquidity problems and those that are insolvent, and have
incentives to determine the appropriate loan rate to charge than is a central
bank, such as the Federal Reserve. Indeed, Schwartz (1988) notes that the
Federal Reserve frequently confuses financial distress (individual bank
problems) with financial crisis (banking system problems). Thus, the lender
of last resort should provide liquidity to the banking system as a whole
through open-market operations (macro-liquidity), rather than directly to
individual banks through the discount window (micro-liquidity) (Goodfriend
and King, 1988, and Kaufman, 1991).

5.2 International Lender of Last Resort
Kindleberger (1978), Eichengreen and Portes (1987), and Guttentag and
Herring (1987), among others, call for the establishment of an international
lender of last resort, as a means of preventing banking panics from spreading
from country to country. However, as we discuss above, there is no reason to
believe that the banking and payments systems of individual countries cannot
be protected fully by these countries' domestic lenders of last resort.
Furthermore, there is no international money supply. Hence, there cannot be a
multiple contraction of money and credit should depositors who fear the
collapse of one or more banks run to currency.

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Although the failure of a bank can cause disruptions in the operations of its
customers and correspondents headquartered in other countries, the costs
imposed on these parties are no different than the costs imposed as a result of
the failure of other firms. Nor is there any reason to believe that banks, as
well as nonbanks, would not act to protect themselves from such failures.
Consequently, we see no role for an international lender of last resort,
although international cooperation and the prompt sharing of relevant data
would be beneficial. 19

6. Conclusions and Policy Recommendations
Primarily because of the short-term nature of its liabilities and low capital
ratios, banking is fragile. Banks can and do fail. But so do firms in other
industries. Nor is the failure rate for banks significantly greater than that for
nonbanks. We delineate and examine several proposed explanations for near
simultaneous multiple failures of banks that have occurred in the past,
particularly in the United States. These explanations include excessive
expansion of credit, runs caused by depositors' inability to value banks' assets
when the economy turns down or important firms fail (asymmetric
information), exogenous withdrawals of reserves that are unrelated to
weaknesses in bank asset values, and institutional and legal restrictions that
weaken banks. From our review of the theory and evidence, we conclude that
past multiple bank failures are consistent with the asymmetric information
hypothesis, but were due primarily to the last two reasons
unexpected
declines of aggregate bank reserves and institutional and regulatory
restrictions. We find little evidence supporting the hypothesis that banking is
inherently unstable.
Indeed, banking appears no more unstable than most other industries, whose
failure rate is no less than that of banks, despite the fact that, at least in the
United States, banks have been prevented by regulation from reducing risk
more effectively through geographic and product diversification. Bank
managers, owners, creditors and the market appear to be aware of the risks
faced by banks and their greater fragility. Assuming that bank owners' and
creditors' investments are at risk, there is no reason to believe that bank
managers will not pursue effective risk management and control procedures to
maintain profitability and solvency, much as do managers of nonbanking
firms. As with other fragile objects, breakage need not be greater if
appropriate care is taken, and bankers appear to have taken such care in the
absence of government-imposed incentives to the contrary.

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Bank failures are widely perceived to be contagious to other banks. Thus,
bank failures are viewed as potential economic catastrophes. But there is
little, if any, empirical evidence in support of this doomsday scenario. History
indicates that, at the margin, bank customers have been able to distinguish
good from bad banks and almost all runs have been bank specific. Although
funding might be withdrawn quickly from insolvent banks, it is generally
redeposited equally quickly at solvent banks, so that runs into currency or
banking panics stemming from bank failures have been rare. When such runs
have threatened, banks have been reasonably successful in taking collective
action to limit the impact, both in terms of spill over to other sectors and in
terms of duration. Little if any evidence suggests that bank failures, runs, and
even panics ignited downturns in aggregate economic activity. Rather, the
evidence strongly suggests that exogenous reductions in bank reserves that are
not replaced by the central bank and serious downturns in the economy ignite
banking problems. (Banking problems, though, may, worsen conditions in the
rest of the economy.)
Moreover, the potential for all bank panics is reduced almost to zero when
central banks act intelligently and restore aggregate reserves (not individual
bank reserves) that would be reduced in runs to currency or do not prevent
banks from taking their own corrective actions (both actions that the Federal
Reserve failed to do in the early 1930s). Furthermore, credible deposit
insurance exists on small deposits that can practically be converted into
currency. Hence, there is little reason to expect a destabilizing run to
currency.
The cost of individual bank failures is relatively small and not greatly
different from the failure of any nonbank firm of comparable importance in its
community. In fact, on average, the societal cost of preventing insolvent
banks from failing is considerably greater, as such actions make excessive risk
taking by banks more likely to occur. The simultaneous failure of large
numbers of banks could be more costly if the credit and payments systems
were disrupted. However, we emphasize that such failures can be prevented
both by the central bank's acting as a lender of last resort that provides macro­
liquidity to the banking system, and by governments not offering mispriced
guarantees that encourage banks to assume greater risks than otherwise.
Loans to individual banks are neither necessary nor cost effective. Similarly,
we see no role for an international lender of last resort.
The policy solutions for preventing potential breakdowns from becoming
actual breakdowns are straightforward and clear cut. Government should

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remove restrictions that prevent banks from voluntary risk reduction (e.g.,
geographic and product restrictions for banks and appropriate use of
derivatives), should provide incentives for clearing in good funds for the
payments system, and be prepared to replace fully any aggregate reserves lost
from currency runs. Government should be no more concerned with the
failure of individual banks than with the failure of any other individual firms
in any industry.
The solution to greater safety is to enhance efficiency and accountability in
banking and bank regulation rather than decreasing either or both. We have
outlined elsewhere what we believe to be an appropriate and feasible way of
accomplishing these goals aggregate reserves lost from currency runs.
Government should be no more concerned with the failure of individual banks
than with the failure of any other individual firms in any industry.
The solution to greater safety is to enhance efficiency and accountability in
banking and bank regulation rather than decreasing either or both. We have
outlined elsewhere what we believe to be an appropriate and feasible way to
accomplishing these goals within the restrictions of the existing federal
government deposit insurance structure. Evidence from both this country and
nearly all other major countries suggests that primarily for political reasons
this structure is unlikely to be scaled back dramatically so that the federal
government retains a direct interest in the financial well being of insured
depository institutions. To minimize its potential losses, the government
needs to reduce if not eliminate the now well recognized moral hazard
problem for banks and principal-agent problem for regulators. (Benston and
Kaufman, 1988). In brief, this may be achieved by requiring insured
institutions to hold higher amounts of capital than they have held since the
introduction of deposit insurance, amounts the market would deem in the
absence of deposit insurance to be sufficient to absorb most losses that might
incur. Capital should be measured in terms of the market values of banks'
assets and liabilities. If capital were defined to include subordinated
debentures that cannot be redeemed and that have a remaining maturity of at
least two years, this higher capital requirement would not impose higher tax or
other costs on banks, except for the effective removal of a deposit-insurance
subsidy. The capital requirement would be enforced by a system of structured
early intervention and resolution (SEIR) by regulators to make it more
effective in discouraging poor and opportunistic management.
As a bank’s capital-to-assets ratio declined through pre-specified tranches or
"trigger points," the banking regulatory authorities first could and then would

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have to impose restrictions on dividends and interest payments on
subordinated debentures, expansion, fund transfers to affiliates, etc.
Supervision and field examinations of banks would be conducted to ascertain
that banks were reporting their capital correctly and were not engaged in
extremely risky, illegal, or grossly incompetently managed activities. Banks
with higher capital levels would be permitted to engage in a wider range of
activities and be subject to less intense prudential regulation. Such carrots are
as important as the sanction sticks. This structure is designed to mimic the
sanctions the private market imposes on troubled noninsured firms and thus
minimizes dead weight losses relative to other regulatory alternatives
proposed (Benston and Kaufman, 1988).
A somewhat weaker version of SEIR was adopted in the FDIC Improvement
Act of 1991.20 Although the capital ratio defining the tranches are lower, and
regulatory discretion is broader than we would prefer, the act appears to be
working well in reducing the number and cost of bank failures and in
producing a healthier industry.21 If it were enacted fully and administered
rigorously, we see no reason for banks to be regulated prudentially with
respect to where they can operate, the products they can afford to offer
consumers, the assets they can own, or their ownership by nonbank firms.

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Footnotes
*Kindleberger (1978) describes numerous examples o f all sorts, stretching over several centuries
and many countries. A recent example o f a Ponzi scheme (named for a 1920s Boston promoter) is
what once was Russia’s largest investment company, the MMM stock fund. Despite presenting no
information on how it generated earnings, and repeated warnings by the government against
purchasing the stock, the price of MMM shares rocketed from about a dollar in February to $50 in
July, 1994, as the company drove up the price by repurchasing shares at higher and higher prices.
The scheme collapsed when the government acted to close it down. (New York Times, July 30,
1994, pp. A1 and A4.)
^See Benston, et. al (1986), pp. 42-45 for a more extensive discussion.
^See Benston (1992) for an analysis of the effects o f moral hazard in reducing the value to banks
of securitizing commercial loans.
^They reference eight earlier works that make this point, dating back to 1987.
^ See Horvitz (1990) for Texas and Randall (1993) for New England.
^Minsky's (1972) extensive description of his theory, or his subsequent discussions (1977, 1991)
do not provide specific examples or studies that illustrate or support his theory. He does state
(ibid., 1977, p. 139) that "the incipient financial crises of 1966, 1969-1970, and 1974-1975 were
neither accidents nor the result o f policy errors, but the result o f the normal functioning of our
particular economy." These dates appear to be associated with increases in credit; otherwise, he
offers no explanation as to why he identifies them as "incipient financial crises." In his 1991
"clarification" he does not give examples or cite any studies. Neither does he mention the fact that
the massive failure of savings and loan associations and the large number o f bank failures
experienced in the late 1980s did not give rise to or were associated with financial crises.
^Bordo's paper was published before the world-wide stock market crash o f 1987. That crash did
not result in financial crises in any country, which is inconsistent with the intemationaltransmission-of-financial-crises hypothesis.
®He states (ibid., note 4, p. 285) "One could use the deposit/currency ratio instead of the interest
rate as the dependent variable in our tests with similar results." Presumably, he actually did this
test and found similar results.
^Mishkin calls this the "monetarist" explanation. Because he does not consider exogenous
outflows of high-powered money, we prefer not to use this label.
l^For example, he concludes that "the Roosevelt administration terminated the nationwide bank
panic by successfully conveying information about the soundness of individual banks" following
the March 1933 bank holiday. Park does not consider Wigmore’s (1987) explanation that the bank
holiday was necessitated by a run on gold, which was ended when the Roosevelt administration
de-monetized gold.
* *See Calomiris and Gorton (1991, pp. 121 - 124) for descriptions of and references to nine such
articles.
*“See Gorton (1985) and Park (1991), Gorton and Calomiris (1991, section 4.3), Tallman (1988)
and Dwyer and Gilbert (1989).
l^Such periods are defined as bank panics by Schwartz (1988).
l^See Benston, et. al (1986), p. 39 for references to studies.
^ S e e Tussig (1967) for an early explication o f the benefits o f bank failure, and Kaufman (1988)
for an more extensive discussion.

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l^The evidence is reviewed more completely in Kaufman (1994A), which includes references to
the research from which the conclusions are drawn.
^Flannery (1994) argues that banks issue demandable debt in part as a means o f insuring
creditors that their funds are likely to be safe from loss.
l^Under the Federal Deposit Insurance Corporation Improvement Act o f 1991 (FDICIA), the
Federal Reserve would lose the interest on loans it made to banks that failed.
l^See Benston (1994) for a more extensive analysis.
^ S e e Benston and Kaufman (1994) for a description of the provisions included in FDICIA and
an analysis of the differences with SEIR as proposed by Benston and Kaufman (1988) and others.
Kaufman (1994B).

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45

Working Paper Series
A series of research studies on regional economic issues relating to the Seventh Federal
Reserve District, and on financial and economic topics.
REGIONAL ECONOM IC ISSUES
Estimating Monthly Regional Value Added by Combining Regional Input
With National Production Data
Philip R. Israilevich and Kenneth

WP-92-8

N. Kuttner

Local Impact of Foreign Trade Zone

WP-92-9

David D. Weiss

Trends and Prospects for Rural Manufacturing

WP-92-12

William A. Testa

State and Local Government Spending—The Balance
Between Investment and Consumption

WP-92-14

Richard H. Mattoon

Forecasting with Regional Input-Output Tables

WP-92-20

P.R. Israilevich, R. Mahidhara, and G.J.D. Hewings

A Primer on Global Auto Markets

WP-93-1

Paul D. Ballew and Robert H. Schnorbus

Industry Approaches to Environmental Policy
in the Great Lakes Region

WP-93-8

David R. Allardice, Richard H. Mattoon and William A. Testa

The Midwest Stock Price Index—Leading Indicator
of Regional Economic Activity

WP-93-9

William A. Strauss

Lean Manufacturing and the Decision to Vertically Integrate
Some Empirical Evidence From the U.S. Automobile Industry

WP-94-1

Thomas H. Klier

Domestic Consumption Patterns and the Midwest Economy
Robert Schnorbus and Paul Ballew




WP-94-4

W orking paper series continued

T o Trade or N ot to Trade: W ho Participates in R EC LA IM ?

WP-94-11

Thomas H. Klierand Richard Mattoon
Restructuring & W orker D isp lacem en t in the M idw est

WP-94-18

Paul D. Ballew and Robert H. Schnorbus

ISSUES IN FINANCIAL REGULATION
Incentive C on flict in D eposit-Institution Regulation: E vidence from A ustralia

WP-92-5

Edward J. Kane and George G. Kaufman
Capital A dequacy and the Growth o f U .S. Banks

WP-92-11

Herbert Baer and John McElravey
Bank C ontagion: Theory and E vidence

WP-92-13

George G. Kaufman
Trading A ctivity, Progarm Trading and the V olatility o f Stock Returns

WP-92-16

James T. Moser
Preferred Sources o f M arket D iscip lin e: D epositors vs.
Subordinated D ebt H olders

WP-92-21

Douglas D. Evanoff
An Investigation o f Returns C onditional
on Trading Perform ance

WP-92-24

James T. Moser and Jacky C. So
The E ffect o f C apital on Portfolio R isk at L ife Insurance C om panies

WP-92-29

Elijah Brewer III, Thomas H. Mondschean, and Philip E. Strahan
A Fram ework for E stim ating the V alue and
Interest Rate R isk o f Retail Bank D ep osits

WP-92-30

David E. Hutchison, George G. Pennacchi
Capital S h ock s and Bank G ro w th -1973 to 1991

WP-92-31

Herbert L. Baer and John N. McElravey
The Im pact o f S& L Failures and R egulatory C hanges
on the C D M arket 1987-1991

WP-92-33

Elijah Brewer and Thomas H. Mondschean




2

W orking paper series continued

Junk B ond H old in gs, Prem ium Tax O ffsets, and R isk
E xposure at L ife Insurance C om panies

WP-93-3

Elijah Brewer IIIand Thomas H. Mondschean
Stock M argins and the C onditional Probability o f Price R eversals

WP-93-5

Paul Kofman and James T. Moser
Is There L if(f)e A fter D T B ?
C om p etitive A sp ects o f C ross Listed Futures
Contracts on S ynchronous M arkets
Paul Kofman, Tony Bouwman and James T. Moser

WP-93-11

Opportunity C ost and Prudentiality: A R epresentativeA gen t M odel o f Futures C learinghouse B ehavior
Herbert L. Baer, Virginia G. France and James T Moser

WP-93-18

T he O w nership Structure o f Japanese Financial Institutions

WP-93-19

Hesna Genay
O rigins o f the M odern E xch an ge C learinghouse: A History o f Early
C learing and Settlem ent M ethods at Futures E xchanges

W P-94-3

James T. Moser
T he E ffect o f B ank-H eld D erivatives on Credit A ccessib ility
Elijah Brewer III, Bernadette A. Minton and James T. Moser
Sm all B u sin ess Investm ent C om panies:
Financial C haracteristics and Investm ents

WP-94-5

WP-94-10

Elijah Brewer IIIand Hesna Genay

MACROECONOMIC ISSUES
A n E xam ination o f C hange in Energy D ep en d en ce and E fficien cy
in the S ix Largest E nergy U sin g C o u n tries--1970 -1 9 8 8

WP-92-2

Jack L. Hervey
D o e s the Federal R eserve A ffect A sset Prices?

W P-92-3

Vefa Tarhan
Investm ent and M arket Im perfections in the U .S . M anufacturing Sector

WP-92-4

Paula R. Worthington




3

W orking paper series continued

B u sin ess C y cle D urations and Postw ar Stabilization o f the U .S . E conom y

WP-92-6

Mark W. Watson
A Procedure for Predicting R ecessio n s w ith Leading Indicators: E conom etric Issues
and R ecent Perform ance

WP-92-7

James H. Stock and Mark W. Watson
Production and Inventory Control at the General M otors Corporation
During the 1920s and 1930s

WP-92-10

Anil K. Kashyap and David W. Wilcox
Liquidity E ffects, M onetary P olicy and the B u sin ess C ycle

WP-92-15

Lawrence J. Christiano and Martin Eichenbaum
M onetary P olicy and External Finance: Interpreting the
B ehavior o f Financial F lo w s and Interest Rate Spreads

WP-92-17

Kenneth N. Kuttner
T esting Long Run Neutrality

WP-92-18

Robert G. King and Mark W. Watson
A Policym aker's G uide to Indicators o f E conom ic A ctivity
Charles Evans, Steven Strongin, and Francesca Eugeni

WP-92-19

Barriers to Trade and U nion W age D ynam ics

WP-92-22

Ellen R. Rissman
W age Growth and Sectoral Shifts: Phillips Curve Redux

WP-92-23

Ellen R. Rissman
E xcess V olatility and The S m oothing o f Interest Rates:
An A p plication U sin g M oney A nnouncem ents

WP-92-25

Steven Strongin
Market Structure, T ech n o lo g y and the C yclicality o f Output

WP-92-26

Bruce Petersen and Steven Strongin
T he Identification o f M onetary P olicy Disturbances:
E xplaining the Liquidity P uzzle

WP-92-27

Steven Strongin




4

W orking paper series continued

Earnings L o sses and D isp laced W orkers

WP-92-28

Louis S. Jacobson,Robert J. LaLonde,and Daniel G. Sullivan
S om e Em pirical E v id en ce o f the E ffects on M onetary P olicy
Shock s on E xch an ge R ates

WP-92-32

Martin Eichenbaum and Charles Evans
An U n ob served -C om p on en ts M odel o f
C onstant-Inflation Potential Output

WP-93-2

Kenneth N. Kuttner
Investm ent, C ash F low , and Sunk C osts

WP-93-4

Paula R. Worthington
L esson s from the Japanese M ain Bank S ystem
for Financial System R eform in Poland

WP-93-6

Takeo Hoshi,Anil Kashyap, and Gary Loveman
Credit C onditions and the C yclical B ehavior o f Inventories

WP-93-7

Anil K. Kashyap, Owen A. Lamont and Jeremy C. Stein
Labor Productivity D uring the Great D epression

WP-93-10

Michael D. Bordo and Charles L. Evans
M onetary P olicy S h ock s and Productivity M easures
in the G -7 C ountries

WP-93-12

Charles L. Evans and Fernando Santos
C onsum er C on fid en ce and E con om ic Fluctuations

WP-93-13

John G. Matsusaka and Argia M. Sbordone
V ector A u toregression s and C ointegration

WP-93-14

Mark W. Watson
T esting for C ointegration W hen S om e o f the
C ointegrating V ectors Are K now n

WP-93-15

Michael T. K. Horvath and Mark W. Watson
T echnical C hange, D iffu sio n , and Productivity

WP-93-16

Jeffrey R. Campbell




5

W orking paper series continued

E con om ic A ctivity and the Short-Term Credit Markets:
An A n alysis o f Prices and Q uantities

WP-93-17

Benjamin M. Friedman and Kenneth N. Kuttner
C yclical Productivity in a M odel o f Labor Hoarding

WP-93-20

Argia M. Sbordone
The E ffects o f M onetary P olicy Shocks: E vidence from the F low o f Funds

WP-94-2

Lawrence J. Christiano, Martin Eichenbaum and Charles Evans
A lgorithm s for S olvin g D ynam ic M od els with O ccasionally B inding Constraints

WP-94-6

Lawrence J. Christiano and Jonas D.M. Fisher
Identification and the E ffects o f M onetary P olicy Shocks

WP-94-7

Lawrence J. Christiano, Martin Eichenbaum and Charles L. Evans
Sm all Sam ple B ias in G M M E stim ation o f C ovariance Structures

W P-94-8

Joseph G. Altonji and Lewis M. Segal
Interpreting the P rocyclical Productivity o f M anufacturing Sectors:
External E ffects o f Labor H oarding?

WP-94-9

Argia M. Sbordone
E vid en ce on Structural Instability in M acroeconom ic T im e Series R elations

WP-94-13

James H. Stock and Mark W. Watson
The Post-W ar U .S. P hillips Curve: A R evision ist E conom etric History

WP-94-14

Robert G. King and Mark W. Watson
The Post-W ar U .S . P hillips Curve: A C om m ent

WP-94-15

Charles L. Evans
Identification o f In flation-U nem ploym ent

WP-94-16

Bennett T. McCallum
The Post-W ar U .S . P hillips Curve: A R evision ist E conom etric History
R esp on se to E vans and M cC allum

WP-94-17

Robert G. King and Mark W. Watson




6

W orking paper series continued

E stim ating D eterm in istic Trends in the
Presence o f Serially C orrelated Errors

WP-94-19

Eugene Canjels and Mark W. Watson
S o lv in g N onlinear R ational E xpectations
M od els by Param eterized Expectations:
C on vergen ce to Stationary Solutions

WP-94-20

Albert Marcet and David A. Marshall
T he E ffect o f C ostly C onsum ption
A djustm ent on A sset Price V olatility

WP-94-21

David A. Marshall and Nayan G. Parekh
T he Im plications o f First-Order R isk
A version for A sset M arket R isk Prem ium s

WP-94-22

Geert Bekaert, Robert J. Hodrick and David A. Marshall
A sset Return V olatility with E xtrem ely Sm all C osts
o f C onsum ption A djustm ent

WP-94-23

David A. Marshall
Indicator Properties o f the Paper-B ill Spread:
L esson s From R ecent E xperience

WP-94-24

Benjamin M. Friedman and Kenneth N. Kuttner
O vertim e, Effort and the Propagation
o f B u sin ess C y cle Sh ock s

WP-94-25

George J. Hall
M onetary p o licies in the early 1990s—reflections
o f the early 1930s

WP-94-26

Robert D. Laurent
T he Returns from C lassroom Training for D isp laced W orkers
Louis S. Jacobson, Robert J. LaLonde and Daniel G. Sullivan

W P-94-27

Is the B anking and P aym ents System Fragile?

WP-94-28

George J. Benston and George G. Kaufman




7