Bank failures

Before the 1940’s, bank failures were a major contributor to business depressions, depriving depositors of their money and reducing the availability of loans. Since then, insurance provided by the FDIC has helped minimize the effects of failures on the overall U.S. economy.

The U.S. banking system has long been characterized by a large number of relatively small banks, mostly operating on a local basis only. Such small institutions are often unable to diversify their assets, and they are thus at risk for insolvency. Further, banks have often faced liquidity problems–that is, they have found it difficult to maintain enough cash on hand to meet depositors’ demands. After 1933, the operations of the Federal Reserve and the Federal Deposit Insurance CorporationFederal Deposit Insurance Corporation (FDIC) greatly reduced both the solvency and the liquidity problems of American banks.Bank failures

The Eighteenth and Nineteenth Centuries

After the United States achieved independence, banks were organized in major cities, mostly chartered by state governments. They received little government supervision. The banks financed their loans by issuing banknotes, which circulated as money. Fraudulent operators could print such notes, “lend” them to themselves, spend them a long way from home, and then disappear before the notes were presented for payment. The Farmers Exchange Bank of Gloucester, Rhode Island, for example, failed in 1809 with $800,000 in note liabilities and $86 in cash assets.

The first (1792-1812) and second (1816-1841) federally chartered Banks of the United States held the nation’s other banks accountable, constantly returning their notes for payment. The Bank of the United States, SecondSecond Bank aroused the ire of President Andrew Jackson and lost its federal charter. It became heavily involved in loans intended to raise the export price of cotton during the 1830’s, and it failed in 1841–the largest bank failure to that date. The economy experienced a violent boom-and-bust after 1837, and about one-fourth of American banks failed between 1839 and 1842, reducing the money supply from $250 million during the mid-1830’s to about $170 million in 1841-1842. Banks that were not insolvent often temporarily suspended the conversion of their liabilities into cash and continued to operate.

Although a number of states established effective bank supervision, thinly settled frontier areas remained vulnerable to “wildcat banking.” Another boom-and-bust sequence occurred during the 1850’s, but by 1860, there were more than 1,500 banks. During the Civil War, the National Banking Acts of 1863 and 1864 authorized federal chartering of “national” banks. A punitive tax on state institutions’ banknotes persuaded most existing banks to join the national system. National banks could issue banknote currency, but only by pledging collateral of U.S. Treasury securities. Banknote holders were thus protected against loss.

Cash reserves were required for deposits, but banks outside the major cities could hold part of their reserves on deposit with a big-city bank, thus “pyramiding” reserves. The system was still vulnerable to panics involving deposits. One such Panic of 1873panic in 1873 resulted from the failure of Philadelphia financier Jay Cooke’s banking firm, which was heavily invested in new issues of railroad bonds that it could not sell.

The Early Twentieth Century

After another banking panic in 1907-1908, Congress in 1913 created the Federal ReserveFederal Reserve system to furnish an “elastic currency”–Federal Reserve notes, which could expand in supply when members of the public insisted on cashing their bank deposits. National banks were required, and other banks were permitted, to become “member banks,” holding reserves with the Federal Reserve and privileged to borrow from it. The expectation was that banks would borrow newly issued currency to meet panic demands from their depositors.

In 1900, the United States had about 12,000 banks, and that number was rising rapidly, reaching 30,000 in 1921–the all-time peak. Most of these were small banks in small communities. Federal Reserve estimates of bank suspensions averaged 130 per year between 1892 and 1900, despite 491 banks failing in the panic year of 1893. The estimate fell to 81 failures per year between 1901 and 1910 and 94 per year from 1911 to 1920. Then things changed. In 1921-1922, the economy experienced a sharp recession, which was followed by a sustained deflation of farm prices. The failure rate among small rural banks escalated as farm loans went into default. Between 1921 and 1929, a staggering 5,700 banks failed. These failing institutions held about $1.6 billion in deposits, but their depositors ultimately lost only about one-third of this total.

Worried customers gather outside a New York City bank after it was closed in April, 1932.

(National Archives)

In mid-1929, the U.S. economy entered the worst economic downswing in its history, and bank failures were an important contributing factor. A major New York City bank, the Bank of the United States, failed in December, 1930, unleashing a nationwide run on the banking system. The bank had been heavily involved in stock and real estate speculation. By the time the panic ended in 1933, 9,000 banks holding deposits of $6.8 billion had suspended operations, and their depositors had lost $1.3 billion.

Most of the banks that failed in 1930-1931 had already been in shaky condition when the downswing began, but others were dragged down by deteriorating business conditions. The mass failures depleted the national money supply, which declined from $27 billion in 1929 to $20 billion in 1933. Bank lending declined to the same degree. These factors help explain why the Great Depression;bankingGreat Depression was so long and so severe.

After 1933

On his inauguration in March, 1933, President Franklin D. Roosevelt declared a national bank holiday, closing all the banks and administering another deflationary shock. As the banks reopened, however, depositor confidence returned. The Banking Acts of 1933 and 1935 created a federal program of insurance of bank deposits, and virtually all banks joined. The newly created FDIC was given the power to regulate insured banks. From 1934, the number and impact of bank failures decreased to such an extent that their effects on the U.S. economy became inconsequential. In the recession of 1937-1938, 59 banks failed, and that was the highest number of failures in any year between 1934 and 1941.

Bank failures were not eliminated, for individual banks continued to take risks. One major failure, for example, involved the Franklin National Bank in 1974–then the nation’s twentieth-largest bank. Other major episodes involved the Penn Square Bank (1982) and Continental Illinois (1984). After a flurry of failures during the early 1990’s, the annual failure rate dropped into single digits from 1995 through 2007, except during 2002, when 12 banks failed.

The 2008 Financial Crisis

Involvement of banks in subprime mortgage lending led to a rise in bank failures in the 2007-2008 Financial crisis of 2008financial crisis, reaching a level not experienced since 1994. IndyMacIndyMac, which failed in July, 2008, had roughly $1 billion in uninsured deposits held by 10,000 depositors. Washington MutualWashington Mutual (WaMu) failed in late September, 2008. With more than $300 million in reported assets, it was the largest bank failure in American history. JPMorgan ChaseJPMorgan Chase took over the bulk of WaMu’s deposits and branches. However, the transaction wiped out WaMu’s stockholders and most of its nondeposit creditors. In early October, WachoviaWachovia was rescued by absorption into Wells Fargo on terms that preserved value for all depositors.

The financial rescue legislation of October 3, 2008, theEmergency Economic Stabilization Act of 2008Emergency Economic Stabilization Act, reduced the likelihood of further bank failures by increasing deposit insurance coverage from $100,000 to $250,000.

Bank failures Summary