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The History of U.S. Banking Crises: Cause and Effect

The History of U.S. Banking Crises: Cause and Effect

admin / January 23, 2019

According to economists a banking crisis can only be considered a banking crisis if there is a systematic panic (Calomiris, 2008, p.1). This simply means that the panic is widespread and affects national banks and a great number of people. A bank in the rural United States, failing due to problems in agriculture and the farmers unable to pay their loans is a financial problem but cannot be considered a banking crisis.

In order for an event to be considered it has to create an impact as widespread the current financial crisis of the first decade of the 21st century. In this case the systematic panic came as the mismanagement of the U.S. subprime lending sector and it has something to do with the unique structure of the U.S. banking industry.

The problem with bank losses and the ensuing panic that it creates is nothing new. Financial crisis has been documented as far back as ancient times in the financial industry of Greece and even in Rome in 33 A.D. (Calomiris, 2008, p.2). Even in other parts of Europe and in the United States banks losing money and depositors dismayed by the insolvency of banks are common occurrences. These problems may occur regularly but oftentimes these are isolated cases and its effects not given the chance to consolidate to create widespread panic.

Experts even agree that for most of modern history, banks were perceived to be stable and that large losses from failed banks are uncommon (Calomiris, 2008, p.2). But the unique structure of the U.S. banking industry is the reason why banks are now being perceived as unstable. In the past a central bank and a few policies were enough to prevent a meltdown but the American experience proves that more stringent measures should be in place.

There is also a need to point out that major financial crisis in the United States appears to be a replay of past events. The details may not be the same but there similarities such as the link between the decline of the stock prices and the panic that resulted from news that several businesses are failing.

In other words the U.S. banking industry is easily undermined by panic and there seems to be no system in place that prevents the general public from pulling down the banking sector with bank runs and other actions that multiplies the fears of the people and investors.

There is indeed a pattern that can be observed starting from the early 1900s to the 1930s and now in the 21st century. There is a replay of familiar historical phenomena (Calomiris, 2008, p.1) This means that the problem is not with the economy and U.S. industries per se but the system that was created to manage the U.S. market, banking sector and overall economy that created the opportunity for speculation, confusion, and panic.

A background history of the formation of the United States will reveal the uniqueness of the U.S. Federal Government. As a result, U.S. laws are different from those that can be found in other countries. A deeper understanding of this issue can be achieved if one will compare the U.S. banking industry and the Canadian banking industry.

Before going any further it is important to point out that Canada did not experience any form of systematic panic (Calomiris, 2008, p.3). In fact, the Canadians did not see the need to establish a central bank up until 1935 (Calomiris, 2008, p.3).

The key difference is that the United States government did not allow branch banking throughout the country (Calomiris, 2008, p.3). This is not the same case with Canada. By allowing branch banking throughout the nation, the Canadian government ensured that there is geographical diversity and made it close to impossible for a negative chain-reaction of events that will trigger a system-wide panic.

There is a good explanation why the Canadians were able to create this structure and why the Americans failed to mimic an effective system of banking governance. First of all it was relatively cheaper for Canadians to establish branches nationwide. Secondly, the Canadian government was able to establish a system that made it easier for banks to coordinate with each other in times of confusion.

It has to be understood that confusion is one of the most potent force that creates fear and bank runs among depositors. Finally, the Canadian banking system encouraged the establishment of smaller-sized banks and the assets of these banks were highly concentrated in several nationwide institutions (Calomiris, 2008, p.3).

Thus, the Bank of Montreal can coordinate activities by large banks so that financial crises can be addressed without the knowledge of the general public and therefore preventing panic (Calomiris, 2008, p.3). The situation is far different in the United States.

The most significant flaw in the U.S. banking industry is that it does not allow nationwide branching of banks and this resulted in an undiversified industry compartmentalized within each state and created a system that is insulated from competition. This is the reason why it is prone to shocks.

Whenever there is a decline in stock prices and there is news of a increase in the liabilities of failed businesses then confusion and panics will ensue (Calomiris, 2008, p.3). Although this should be expected as a regular feature of business the United States has no effective means to reduce the occurrence of a systematic panic and the negative impact that it creates.

All of the above-mentioned factors played a major role in the creation of the financial crisis of the 21st century that did not only come to impact America but the whole world. Aside from the structure of the banking industry there is another major factor that resulted in the current crisis.

It is none other than the policies that were enacted to supposedly safeguard the economy but in light of recent events it may had backfired. The most significant policy according to financial experts is the significant government protection of banks, specifically the U.S. federal deposit insurance (Calomiris, 2008, p.4). In theory the idea of having deposit insurance assuages the fears of depositors and should reduce the occurrence of bank runs. However, there are unexpected results.

There are those who argue that deposit insurance created another set of problems. Since there is the assurance that deposits are insured to certain degree then depositors will not be as vigilant as they are before when it comes to their savings. There is less incentive to monitor their banks and a result the banks will find it easier to take risks.

They know that there is a safety net that promises to lessen the impact of their fall and therefore this goads them to take bold steps to increase revenue with little regard to the impact of small mistakes that can eventually grow into something unmanageable such as what happened to the subprime lending sector.

The deposit insurance law does not encourage discipline anymore within the U.S. banking industry and therefore imprudent behavior is rewarded and no one will be held accountable. As a result there is a steady increase in the number of incompetent bankers that have tremendous capabilities to play around with funds of other people.

One small problem led to another until the banks could not hide anymore the problem with their loans and insolvency. Due to the lax environment created by the deposit insurance scheme the depositors and U.S. citizens were unable to detect the seriousness of the problem until it was already too late.

It is important to determine the impact of the deposit insurance law and why it contributed much to the failure of many American financial institutions. However, it must also be pointed out that this piece of legislature was considered of utmost necessity after the Great Depression when depositors became wary of banks. Confidence must be restored and this is the main reason why in spite of various oppositions this policy pushed through.

It is also important to determine the possible negative consequences of the removal of deposit insurance. This is because experts are only able to identify one major reason why it must be cancelled. They are saying that it encourages the lack of accountability.

This implies that the removal of deposit insurance will automatically create the opposite attitude which is to force depositors to take a more active role in monitoring banks. Well, this is just an assumption. There is a need to determine if this will be the case or it will reproduce the dreaded financial crisis of the previous century.

Personal Inferences

It is important to be familiar with the history of the U.S. banking industry and the history of financial crises that hit the country from 19th century up to the 21st century. In this manner it is possible to determine a pattern and if the pattern of negative thinking and failed actions resulted from a preceding event or policy then it is easier to pinpoint the flawed directive or piece of legislation and correct it to mitigate risks and prevent another major financial breakdown.

A historical approach will yield better results if this is achieved using comparative studies with other countries. In the study of financial crises that occurred in U.S. mainland, many insights were gleaned from comparing its financial history with that of England and Canada.

It was a revelation to know that Canada was spared from the global financial crisis that ignited from the United States and spread like wildfire to the whole world of finance. This has prompted economists to take a closer look at the explanation for Canadian stability as opposed to its neighbor.

The most glaring difference is the absence of diversity and the fact that the U.S. banking industry was set-up in such a way that it is insulated from competition and also the fact that there is no coordination between national banks to help them weather a financial storm or to become more proactive in putting out fires before even the general public even knows that a potential threat is looming.

This will prevent them from panicking that usually results in the chain-reaction of events that in turn blow-up a small problem into crisis proportions.

Decision-makers and policymakers must take heed to the fact that there seems to be a constant replay of events. There is a pattern that is easy to see if they are only willing to take a long hard look at what transpired in the U.S. banking industry from the 19th century up to the present.

It was indeed the uniqueness of the structure of the U.S. banking industry that allowed for these things to happen. If this is the case then policymakers must make increment steps to slowly but surely educate people and educate bankers on how to be more imprudent when it comes to investments as well as how to be more accountable to stakeholders.

It is also important to allow the government to make more deliberate steps in managing the banking sector. There is the assumption that if policies like deposit insurance will be removed then the general public will go out of their way to monitor banks. This is a mere assumption; the data used were the behavior of American in the early part of the 19th century.

There is no assurance that by rescinding the deposit insurance law that everyone will suddenly become more responsible citizens and more responsible bankers. It must be pointed out that banks will continually find a way to make money and it is also common knowledge that the general public is prone to fear and panic.

The federal government must find a way to balance the need for more control and the need to allow the forces of a free enterprise to dictate where the economy is heading. It is not good to have absolute control but history also tells Americans that it is not prudent to cast out all forms of monitoring and government intervention.

The best thing to do is to educate people on how the banking industry works. It is also imperative for bankers and businessmen to understand the impact of the policies of yesteryears and if there is a need to overhaul those laws considering the pattern of financial crises and the panics that occurred in two centuries of American financing.

Conclusion

A historical approach to the study of the U.S. banking industry will reveal the flaws in the system. This is because a pattern is easily recognizable if one is able to see the big picture and trace the impact of policies made between the 1900s and the 21st century. It is crucial to understand that the United States continuous to suffer from a recurring problem of financial instability and systematic panics.

It has something to do with policies that were enacted in the past. There is therefore a need to review these policies and to evaluate more stringently the way the Federal government sets up the financial sector of this country. There is also a need to find the balance between close government supervision and the principles of a free enterprise.

It has been pointed out that control measure oftentimes backfire because there is no set of rules that can be created that will anticipate all future events and changes in the market and even the world. On the other hand if bankers are allowed to do their own thing then a collapse will be inevitable because they are focused on making profit not necessarily to safeguard the money entrusted to them.

References

Calomiris, C. (2008) Banking Crises. The National Bureau of Economic Research.

Retrieved 05 December 2010 from http://www.nber.org/

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