Bank Regulation, Network Topology, and Systemic Risk: Evidence from the Great Depression

Abstract

We employ a unique hand-collected dataset and a novel methodology to examine systemic risk before and after the largest U.S. banking crisis of the 20th century. Our systemic risk measure captures both the credit risk of an individual bank as well as a bank's position in the network. We construct linkages between all U.S. commercial banks in 1929 and 1934 so that we can measure how predisposed the entire network was to risk, where risk was concentrated, and how the failure of more than 9,000 banks during the Great Depression altered risk in the network. We find that the pyramid structure of the commercial banking system (i.e., the network's topology) created more inherent fragility, but systemic risk was nevertheless fairly dispersed throughout banks in 1929, with the top 20 banks contributing roughly 18% of total systemic risk. The massive banking crisis that occurred between 1930{33 raised systemic risk per bank by 33% and increased the riskiness of the very largest banks in the system. We use Bayesian methods to demonstrate that when network measures, such as eigenvector centrality and a bank's systemic risk contribution, are combined with balance sheet data capturing ex ante bank default risk, they strongly predict bank survivorship in 1934. JEL-Codes: L100, N200.

The Founding of the Federal Reserve, the Great Depression, and the Evolution of the U.S. Interbank Network

“…Carlson, Mitchener, and Richardson (2011) show that correspondent relationships transmitted distress among Florida banks during a crisis in 1929, and Richardson and Van Horn (2018) show that international connections were important for spreading risk to New York City during the Depression. Das, Mitchener, and Vossmeyer (2018) show that network risk measures help predict bank survival to 1934. Calomiris, Jaremski, and Wheelock (2019) find that banks were vulnerable to closures of their correspondents and respondents during the Depression.…”

“…Although New York City and Chicago remained the largest network hubs, the percentage of banks with a New York City correspondent declined after 1900, when 85.4 percent of all U.S. banks had at least one New York City correspondent. Substantial numbers of new banks 8 The literature on networks generally views concentration as one of the most important factors affecting the potential transmission of risk through a network (e.g., Acemoglu, Ozdaglar, and Tahbaz-Salehi 2015;Das, Mitchener, and Vossmeyer 2018). Of course, the extent to which a given correspondent bank contributed to systemic risk depended also on the share of its liabilities comprised of interbank deposits, and its capital and liquidity buffers, all of which play a part in determining the potential loss to the network if the bank were to fail.…”

“…Historical studies have used detailed micro-level data on interbank connections in specific locations or short periods in research on banking panics, contagion, and local economic development 3 . However, other than our article, only Das, Mitchener, and Vossmeyer (2018) use data on the entire network for even a single year. Data on the connections of all banks are vital to understanding the structure of the network.…”

The Founding of the Federal Reserve, the Great Depression and the Evolution of the U.S. Interbank Network

“…Carlson, Mitchener, and Richardson (2011) show that correspondent relationships transmitted distress among Florida banks during a crisis in 1929, and Richardson and Van Horn (2018) show that international connections were important for spreading risk to New York during the Depression. Das, Mitchener, and Vossmeyer (2018) show that network risk measures help predict bank survival to 1934, and Calomiris, Jaremski, and Wheelock (2019) find that during the Depression, banks were vulnerable to closures of their correspondents. Whereas these studies all take network structure as given, our focus here is on how the structure evolved over the three decades before the Great Depression and how it changed during the Depression, and in this way, we provide a long-run perspective that can help inform future studies of network contagion.…”

“…The literature on networks generally views concentration as one of the most important factors affecting the potential transmission of risk through a network (e.g.,Acemoglu, Ozdaglar, and Tahbaz-Salehi 2015;Das, Mitchener and Vossmeyer 2018). Of course, the extent to which a given correspondent bank contributed to systemic risk depended also on the share of its liabilities comprised of interbank deposits, and its capital and liquidity buffers, all of which play a part in determining the potential loss to the network if the bank were to fail.…”