Lessons from banking profits in the great depression

You will find a general consensus today that people should do everything possible in order to avoid large-scale bank failures, and that was not done through the 1930s. However, the impact of the widespread failures that occurred then was a lot more limited than is normally assumed.

The quantity of bank failures rose from an annual average around 600 through the 1920s to at least one 1,350 in 1930 before peaking in 1933 when 4,000 banks were suspended. Over the complete period 1930-1933, one-third of most US banks failed. However, deposit losses remained limited even in this turbulent period at a cumulative 4% (with an annual peak of 2.15% in 1933) of total deposits (of most commercial banks). You can reconcile these relatively modest losses with the large numbers of bank failures?

Table 1. Commercial bank suspensions through the Great Depression

Year Number of Suspensions Deposits (an incredible number of USD) Losses Borne by Depositors (an incredible number of USD) Losses as % of deposits Loss rate in %
Average 1921-28 631 174 61 0.15 35
1929 659 231 77 0.18 33
1930 1350 837 237 0.57 28
1931 2293 1690 390 1.01 23
1932 1453 706 168 0.57 24
1933 4000 3597 540 2.15 15
Cumulative 1930-33 9096 6830 1337 4.3 20

One reason losses to depositors were ultimately quite limited is that, even in failed banks, depositors still received about 80 cents on the dollar, typically. 1

Another key reason was that the amount of concentration in the banking industry was lower then than it really is today. In the mid-1930s, the most notable three banks held about 11% of the full total assets of the industry; in 2008 they held about 40%. Although about one-third of most banks failed between 19, they accounted for no more than 20% of most deposits.

The downside of the fragmentation of the banking sector was that few institutions were thought to be systemic. The failure of anybody of many “mini” banks did thus not arouse particular concern. Hence little was done to avoid the many bank failures that did occur. However, the continuing latent, if actuarially relatively small, threat of banks undermined confidence. Given the lack of a federal deposit insurance system, this undermined the functioning of the bank operating system as banks needed to be extremely cautious given the prospect of runs (mass withdrawals). The negative feedback loop that operates today – weakness of demand resulting in more firms failing and therefore bank losses – was thus amplified by having less a highly effective deposit insurance system and a generally higher willingness to permit banks to fail.

The necessity for a federal deposit insurance system in america was one key lesson learnt, and the creation of the FDIC within the New Deal certainly contributed to the recovery. The lesson that confidence of depositors in the bank operating system is essential has been amply applied in Europe through the present crisis, when EU governments expanded the prevailing deposit insurance systems to cover the holes that the Northern Rock episode exposed.

THE UNITED STATES authorities had to relearn this lesson following the Lehman debacle. Given the large impact of the modest deposit losses through the 1930s, it should not need come as surprise a failure of the size must have extreme consequences. As an investment bank, Lehman didn’t have any deposits from everyone, but its assets around $660 billion were equal to about 5% of the complete US bank operating system.

Moreover, Lehman alone constituted a significant area of the bank bond market, since it had issued about $600 billion of short- and long-term bonds, for a complete around $1200 billion emitted by all commercial banks together.

THE FANTASTIC Depression certainly resulted in a collapse in corporate profits. The organization sector went from profits amounting to over $10 billion (about 10% of GDP) in 1929 to a collective lack of about $1.5 billion (about 2.5% of GDP) in 1932 (see table 2).

Table 2. Corporate Profits before tax, million USD

1929 1930 1931 1932 1933 1934 1935
Total Corporate 10595 4291 357 -1480 1728 3079 4216
Domestic industries (including financial industry) 10363 4154 361 -1446 1730 3019 4057
Finance, insurance, and property 1760 771 473 361 463 236 318
Banking 1003 796 675 576 536 422 466

Strangely enough, in the banking sector, which is considered to have already been the most suffering from the crisis, profits stayed positive throughout this era. Bank’s profits declined by “only” a bit more than 40%, pretty much consistent with nominal GDP. Figure 1 demonstrates bank’s profits were indeed relatively stable as a proportion of GDP (just underneath 1% of GDP).

Figure 1 . Profits in US through the 1930s (before tax as % of GDP)

However, the financial sector outside banking did suffer losses. Banks thus may actually have already been an island of relative stability. The run-up to and aftermath of the existing crisis show similar features, with corporate profits buoyant prior to the crisis but collapsing with the onset of the bust. This boom-and-bust pattern can be pronounced in the financial sector outside banking.

The data going back 25 years displayed in Figure 2 show that generally banking profits display little correlation with GDP growth. This property is shared neither by all of those other financial sector nor the organization sector as whole.

Figure 2. Profits in US after 1980 (before tax)

Because so many observers have a tendency to lump banks and the bigger financial sector together, it really is widely assumed that banks’ profits also increased over the last boom. However, this is not the case. The gains of (commercial) banks as measured by national accounts didn’t noticeably increase up to 2007. The info from the fantastic Depression claim that banks may be more resilient compared to the wider financial sector.

Another reason behind the widespread impression of large profits in banking may be the confusion between your national income accounting concept and the numbers reported in financial statements. The national income accounts usually do not “mark to advertise”. Financial transactions and capital gains and losses linked to transactions of financial securities are thus not contained in the national accounts. Through the boom phase, profits in the national income accounts tend thus to be less than those reported to financial markets (and vice versa through the bust). Profits as measured by the national accounts should thus provide a better picture of underlying, operating profitability of the sector.

The recent batch of relatively reassuring profits reported by many US banks may also be understood in the light of switch from mark-to-market accounting. That a lot of banks can report positive profits resembles the knowledge of the fantastic Depression.
You can explain the relative stability of banks’ profits generally and in particular through the Great Depression? To put it simply, it appears that banks are normally in a position to charge enough of a risk premium to cover the upsurge in non-performing loans during downturns. Today’s crisis confirms this tendency. Much has been manufactured from the IMF’s recent headline estimate of over $4trillion in aggregate losses to the financial sector expected from today’s crisis. However, this figure can be an estimate of the full total over four years (2007-10), and banks take into account no more than 60% of the entire amount. Moreover, about one-half of the losses expected by banks ($2.4 trillion, see table 1.3 of the Global Financial Stability Report, April 2009) are based on the markdown of securities (which wouldn’t normally be contained in national income accounts).

The global average overall loss rate on loans for banks is estimated to be around 5.1%. Considering that that is assumed to be the cumulated loss rate over four years, banks will be able to absorb it with a commensurate upsurge in their spreads. If the losses accrue mostly towards the finish of this period, a rise in the common spread applied by banks of significantly less than 2%should be sufficient to keep banks (typically at least) from making large losses. Banks do seem to be charging such spreads. For instance, the ECB reports that the rates charged by euro area banks to corporate customers are actually around 4.8%; about 2.5% – 3%higher than marginal funding costs as measured by Euribor rates or the rates paid on savings deposits. In america the ‘prime rate’ (the rate charged by banks with their best customers) reaches 3.25%; about 3% above marginal funding costs embodied in the federal funds or the commercial paper rates. This will be sufficient to handle the losses which can be expected even beneath the current fiscal conditions.

Despite its much greater severity, the fantastic Depression didn’t actually lead to higher loss rates. As shown in figure 1.30 of the IMF’s Global Financial Stability Report, commercial mortgage charge-offs peaked for only 1 year at a bit above 5%, however the average for the first 1930s remained between 2 and 3%.

The resilience of “normal” banking operations to a recession or perhaps a depression strengthens the case for a separation of commercial and investment banking activities. The classic banking operations of deposit-taking and lending have a tendency to remain profitable even under stressed conditions. But this classic function of banking wouldn’t normally be such a reason behind concern today if the investment banking arms of banks hadn’t gotten into trouble by buying “toxic” assets. At the moment, the authorities in both US and Europe have little choice but to create up for the losses on “legacy” assets and await banks to earn back their capital. But to avoid future crises of the type, policymakers should be sure that losses from investment banking arms cannot impair commercial banking operations.

Federal Deposit Insurance Corporation (FDIC) (1998), A brief overview of deposit insurance in america
IMF (2009) Global Financial Stability Report (GFSR), Giving an answer to the FINANCIAL MELTDOWN and Measuring Systemic Risks, April

and 1917, eight states established deposits insurance funds but by end of the 1920s that they had all failed (FDIC, 1998)