The Ghost of Banking Panics Future

Making financial crises great again

Note: Some commenters say that the movie, released in 1946, is actually set in the early 30s. I assume they’re right, although I’ll check it. Of course, that doesn’t affect the substance of the post.

One benefit of the rise of streaming is that you can get through holiday season watching movies at home other than endless reruns of “It’s a wonderful life.” If you do find yourself viewing the old chestnut, however, you should be aware that it’s an unrealistic fantasy.

I’m not talking about an angel getting its wings every time a bell rings and all that. True, I haven’t seen any evidence for that claim, but then I haven’t seen any evidence against it either.

No, I’m talking about the bank run at the heart of the plot, which could not have happened at the time the movie was set. For the events in “It’s a wonderful life” take place just after World War II, and by then deposits at thrift institutions like Jimmy Stewart’s bank were covered by the Federal Savings and Loan Insurance Corporation, so his customers would not have been worried about losing their life savings. FSLIC itself went bankrupt in the 1980s — more about that later — but depositors’ money was protected from the savings and loan crisis, and it was folded into the Federal Deposit Insurance Corporation, which covers commercial banks.

Now, however, the incoming Trump administration reportedly wants to abolish the FDIC and weaken bank regulation in general. And that could eventually lead to very bad things.

Bank runs were quite common before the creation of FSLIC and the FDIC — audiences when the movie came out in 1946 still had vivid memories of the huge bank runs of the 1930s. And this was far from the first time bank runs had a devastating effect on the real economy.

In particular, we know that Donald Trump has a thing about the 1890s, when men were men, tariffs were high, businesses were free to pollute the air and water, and nobody knew what went on in meatpacking plants. But you can bet your Bitcoin that he’s never heard of the Panic of 1893, a huge wave of contagious bank runs that was catastrophic for industrial production and employment:

Economists actually understand bank runs pretty well. When the 2008 financial crisis struck after generations without such crises (in the United States), monetary economists could be found wandering the halls muttering “Diamond-Dybvig, Diamond-Dybvig,” after a classic 1983 analysis by Douglas Diamond and Philip Dybvig, who pointed out that banks offer their depositors immediate access to their cash while investing most of the money in “illiquid” assets like loans that can’t be quickly sold, or at least only at fire-sale prices. (Diamond and Dybvig eventually won a Nobel Prize for their work.)

Normally the illiquidity of most bank assets isn’t a problem, because on any given day only some of a bank’s customers want cash, while others are making deposits, so it’s OK to hold limited amounts of ready cash.

But if for whatever reason depositors fear that a bank may be about to fail, they will rush to pull out their money — and their fears can turn into a self-fulfilling prophecy, because a bank trying to raise money in a hurry can go bankrupt even if it would have been solvent if it had had time to sell at a more deliberate pace. And since the collapse of one bank can cause fears about other banks, bank runs can be contagious.

Deposit insurance made old-fashioned bank runs a thing of the past; I’ll talk about recent crises in a minute. But from the beginning it was obvious that protection for depositors had to come with strings. Otherwise banks could play heads I win, tails taxpayers lose: attract funds by offering attractive interest rates, then invest in potentially high-yielding ventures that could also easily go bad. Depositors wouldn’t worry, because they were protected; bank owners would get rich if they were lucky, just walk away if they weren’t.

So deposit insurance had to be accompanied by things like capital requirements that forced bank owners to put their own money at risk and restrictions on the kinds of investments they were allowed to make.

Concerns that unregulated banks would gamble with depositors’ funds weren’t purely hypothetical. The interaction between deposit insurance and deregulation of savings banks in the 1980s turned a modest-sized problem into a huge mess that eventually cost taxpayers around $130 billion — adjusting for inflation and economic growth since then, that’s the equivalent of around $650 billion today.

Still, thanks to deposit insurance we went from the 1930s to 2008 without major banking crises. What happened in 2008?

The answer, which most economists, myself included, unfortunately didn’t recognize until after the fact, was that by 2008 much of the financial system had been taken over by “shadow banking” that functioned a lot like ordinary banking but lacked both guarantees and effective regulation. For example, firms like Lehman Brothers were in effect using overnight borrowing to finance purchases of mortgage-backed securities, creating the conditions for something that was the functional equivalent of a Diamond-Dybvig bank run even though it didn’t involve bank deposits.

And when the runs came, the results were a lot like those of 19^th-century “panics.” We managed to avoid a full replay of the Great Depression thanks to a combination of bailouts and fiscal support, but it was still ugly, and the crisis was followed, appropriately, by tightened regulation of finance in general.

But now the incoming Trump administration seems eager to deregulate the financial industry. We’re hearing about the possibility of abolishing the FDIC. Deposit insurance would supposedly remain, although it would be absorbed into the Treasury Department. But the FDIC has a lot of institutional experience in bank regulation, which would presumably be lost. And this comes amid a general push to loosen financial regulation, indeed regulation of all types.

I have no idea how far this stuff will go, although Wall Street types are clearly eager to start taking dangerous risks again.

But it does seem like a reasonable guess that panics, along with pollution and polio, are well-positioned to make a comeback.

MUSICAL CODA