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Making the Connection

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Fed Policy During Panics, Then and Now: The Collapse of the Bank of United States
in 1930 and the Collapse of Lehman Brothers in 2008
Although the Federal Reserve was established in 1913 to stop bank panics, in fact, the worst bank panic in U.S. history occurred
during the early 1930s, and the Fed did little to stop it. The panic occurred during the Great Depression, which began in August
1929. By the fall of 1930, many commercial banks found that their assets had declined significantly in value, as both households and
firms had difficulty repaying loans. In October 1930, the Bank of United States, a private commercial bank in New York City,
experienced a bank run. It appealed to the Fed for loans that would allow it to survive the liquidity crisis caused by deposit
withdrawals. The term moral hazard had not yet been coined, but Fed officials were clearly familiar with the concept because they
declined to save the Bank of United States on the grounds that the bank's managers had made risky mortgage loans to borrowers
investing in apartment houses and other commercial property in New York City. The Fed believed that saving the Bank of United
States would reward the poor business decisions of the bank's managers. The Fed also doubted that if the bank's assets were sold,
the amount raised would be sufficient to pay off depositors.
Although the Fed's reasons for failing to save the Bank of United States were legitimate, there were adverse financial consequences
for the entire economy. When the bank failed, the faith of depositors in the commercial banking system was shaken. Because
deposit insurance did not yet exist, depositors were afraid that if they delayed withdrawing their money and their bank failed, they
would receive only part of their money backand only after a delay. Further waves of bank failures took place over the next few
years, culminating in the "bank holiday" of 1933, when President Franklin Roosevelt ordered every bank in the country shut down for
a week so that emergency measures could be taken to restore the banking system. Although the Fed's actions during the bank panic
had avoided the moral hazard problem, they resulted in a catastrophic meltdown of the U.S. financial system, which most
economists believe significantly worsened and lengthened the Great Depression.
The figure displayed in the textbook shows for each year from 1920 through 1939 the number of banks that were forced to
temporarily or permanently suspend allowing depositors to withdraw funds. The figure reveals that bank runs in the United States
went from being fairly common in the 1920s, to reaching very high levels in the early 1930s, to practically disappearing after the
FDIC was established in 1934. In fact, the Fed acted as a lender of last resort infrequently over the next 75 years.
In 2008, the Fed was once again confronted with the dilemma of how to deal with the failure of a large financial firm. In the spring,
Bear Stearns, a large investment bank, ran into difficulty because the declining prices for many of the mortgage-backed securities it
held made other financial firms reluctant to lend it money. The Fed and the U.S. Treasury responded by arranging for JPMorgan
Chase, a commercial bank, to purchase Bear Stearns for a very low price. That fall, though, fear of increasing moral hazard led the
Fed and the Treasury to allow Lehman Brothers, also a large investment bank, to declare bankruptcy.
The Lehman Brothers bankruptcy had an immediate negative effect on financial markets. Graphs displayed in the textbook illustrate
the effect of the Lehman Brothers bankruptcy on financial markets. One panel shows the difference between the three-month London
Interbank Offered Rate (LIBOR), which is the interest rate at which banks can borrow from each other, and the interest rate on
three-month Treasury bills. The difference in these two interest rates is called the TED spread and provides a measure of how risky
banks consider loans to each other compared with loans to the U.S. government. After fluctuating in a narrow range around 0.5
percentage point during 2005, 2006, and the first half of 2007, the TED spread rose as problems in financial markets began in the
second half of 2007, and then it soared to record levels immediately following the failure of Lehman Brothers. A second panel shows
the decline in issuing of securities backed by credit card debt. Issuance of these securities plummeted to zero in the last quarter of
2008. Because banks could not sell new credit card loans, they became reluctant to issue new credit cards or increase credit limits
on existing accounts. These measures made it more difficult for households to finance their spending. Many on Wall Street saw the
bankruptcy of Lehman Brothers as such a watershed in the financial crisis that they began to refer to events as having happened
either "before Lehman" (declared bankruptcy) or "after Lehman."
Having failed to intervene to save Lehman Brothers from bankruptcy, the Treasury and the Fed reversed course later that same
week to provide aid to AIGthe largest U.S. insurance companythat saved the firm from bankruptcy. For the remainder of 2008
and into 2009, the Treasury and the Fed appeared to have set aside concerns about moral hazard as they gave no indication that
they would allow another large financial firm to fail. It remains to be seen whether the failure of Lehman Brothers will be viewed as
being as significant an event in the 2007-2009 financial crisis as the failure of the Bank of United States was in the 1929-1933 crisis.
Sources: TED spread: Authors' calculations from British Bankers' Association data and Federal Reserve data; credit card securitization: Peter
Eavis, "The Fed Goes for Brokerage," Wall Street Journal, March 4, 2009; and U.S. Federal Reserve System, Board of Governors, "Bank
Suspensions, 1921-1936," Federal Reserve Bulletin, Vol. 23, September 1937, p. 907.

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7/19/2016 10:53 AM