Not all banking crises cause panic – it can still lead to a broad recession

Historically, “quiet” banking crises without customer panic can lead to losses that could lead to an economic downturn.

Research shows that failures in many financial sectors – not just the most popular banking operations in history – are leading to an economic downturn.

The banking crisis is often seen as a self-fulfilling prophecy: waiting for the bank to fail makes it happen. Look at the people queuing up to withdraw their money during the Great Depression, or the customers who worked at the Bank of Northern Rock in Britain in 2007.

But a new document authored by a partner WITH The professor suggests that we have lost a bigger picture of the banking crisis. Yes, sometimes there are panics about banks that create problems that strengthen themselves. However, many banking crises are calmer: While there is no panic among customers, banks can incur serious losses to create subsequent economic crises.

Emil Werner, an MIT professor who led the study, said: “There is no need to panic if the banking crisis has serious economic consequences.” “But when there is panic, it is the worst episode. Panic is an important reinforcement mechanism for banking crises, but not a necessary condition. ”

Indeed, in an ambitious study covering 46 countries, dating back to 1870, the study examines banking crises that occur with or without panic. When there is panic and bank runaways, research shows that a 30 percent drop in capital in the banking sector predicts a 3.4 percent drop in real GDP (inflation-adjusted gross domestic product) after three years. However, although there is no creditor panic, the bank forecasts a 30 percent decline in equity and a 2.7 percent decline in real GDP in three years.

Thus, virtually all banking crises, not the biggest hits in history, cause long-term macroeconomic damage, as banks are less able to secure the credit they used to expand their business.

“Bank crises often come with very serious recessions,” says Werner, a 1957 professor of career development and assistant professor of finance at MIT Sloan School of Management.

The newspaper “Panic-Free Bank Crisis” was published in the February issue Quarterly Journal of Economics. The authors are Matthew Baron, associate professor of finance at Cornell University; Werner; and Wei Xiong, professor of finance and economics Princeton University.

Serious, quantitative approach

Using the existing databases and adding information from historical newspaper archives, the researchers developed a new database of bank share prices and dividends in 46 countries from 1870 to 2016. They collected non-bank stock prices, monthly credit disbursement data, and macroeconomic data such as GDP and inflation.

“People have historically looked at identifying and identifying different episodes of banking crises, but there hasn’t been a more serious, quantitative approach to identifying these episodes,” Werner says. “There was a ‘know it when you see a little more’ approach.”

Scientists studying past banking crises are roughly divided into two camps. A group focused on the panic, and if the banks had been prevented from operating as a result, the banking crisis would not have been so bad. Another group looked more closely at bank assets and focused on cases where banks’ decisions resulted in large losses, such as bad loans.

“In some ways, we’re down,” Werner said. Panic worsens banking problems, but nonetheless, “There are many examples of a number of banking crises where banks have suffered and stopped lending, businesses and households have difficulty accessing credit, but there has been no escape or panic among creditors. These episodes still led to bad economic consequences. ”

More specifically, a closer look at the monthly dynamics of banking crises shows how often this situation actually occurs with the erosion of the bank’s portfolio and the recognition of this fact by investors.

“It simply came to our notice then. Before them, there is a downward trend in bank shares, “said Werner. “The bank recognizes that its shareholders will suffer the loss of the bank’s debts,” he said. And so, panic is not the main cause of problems in the banking system in general due to bad loans, but in most cases the result. ”

The study identifies how banking was disrupted in this situation. After the apparent panic of the banking crisis, the ratio of average bank lending to GDP fell to 5.7 after three years; that is, there was less bank credit as a basis for economic activity. When there was a “quiet” banking crisis, without any apparent panic, the average bank loan to GDP ratio fell by 3.5 percent after three years.

Historical detective work

Werner says researchers are happy to “do some historical detective work and find some forgotten episodes.” According to him, the expanded group of crises in the study consists of “new information that is already used by other researchers.”

Among the banking crises previously considered in this study are episodes from the 1970s, struggles in Canada during the Great Depression, and banking failures in the 19th century. Researchers have provided versions of the study to a number of politicians, including some regional U.S. Federal Reserve Boards and the Bank for International Settlements, and Werner said he hopes these officials will consider the case.

“I think it’s worth moving forward, not just for a historical perspective,” he said. “In many countries, having a broad example is important to recognize what lessons are learned when new crises occur.”

Researchers continue their research in this area by researching the loans that banks provide before they lose value – for example, identifying the types of businesses that are less likely to repay bank loans. As banks begin to lend more to certain types of companies – most likely restaurants, construction and real estate companies – this may be a sign of a start-up problem.

Reference: “Panic-Free Bank Crisis”, Matthew Baron, Emil Werner and Wei Xiong, October 8, 2020, Quarterly Journal of Economics.
DOI: 10.1093 / qje / qjaa034

Research was supported in part by the Cornell Center for Social Sciences and the New Economic Thought Institute.

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