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Runs and Panics: Lessons from The Past

Happy Sunday, everyone! Since there is so much historical context to dive into, let’s just get straight to it!

The recent banking crisis has elicited comparisons to the ubiquitous 19th century banking panics, with both periods marked by high concentration in specific industries, rapid growth, and eventual crises. Today’s newsletter examines historical parallels between the present-day crisis and 19th-century bank runs and panics. Finally, we will explore the idea that the technology sector has replaced railways as the heart of financial panics in the modern era.

Railway-related crashes in the 19th century, such as the Railway Mania of the 1840s in Britain and the Panic of 1857 in the United States, were marked by over-investment, speculation, and the collapse of numerous railway companies. These events led to widespread financial distress and economic downturns, highlighting the vulnerability of the financial sector to shocks emanating from a single dominant industry. Today, the technology sector has emerged as the new driver of economic growth, innovation, and speculation. This sector’s meteoric rise has paralleled the railway boom of the 19th century, with both industries experiencing rapid expansion, high valuations, and large-scale investment. As with the railways, the technology sector’s dominance has exposed the financial system to the risk of contagion, should this industry start to falter or temporarily stutter.

The recent banking crisis, partially triggered by heavy exposures to technology startups, bears striking similarities to the 19th-century banking panics. In both cases, overinvestment and speculation in a dominant industry led to the collapse of key financial institutions, sparking widespread panic and a scramble to preserve liquidity. Moreover, the regulatory response to the crises, including government interventions and central bank support, highlights the systemic importance of these institutions and the potential for contagion to spread through the financial system.

However, one of the crucial differences between today’s crisis and 19th-century panics is the global web of modern finance, coupled with advances in technology and communication, which has facilitated the rapid transmission of shocks across countries and markets. In fact, it has never been easier to initiate a bank run than right now, since technology enables depositors to withdraw funds in just a few clicks.

Despite these differences, the historical parallels between the current banking crisis and 19th-century panics still offer valuable insights into the vulnerability of the financial system to shocks in dominant industries. Heavy concentrated exposure to the leading industries of the day creates a heightened susceptibility to trouble when that sector starts to underperform.

In short, the present-day banking crisis and 19th-century bank runs and panics share many similarities, particularly in their origins and consequences. The rise of the technology sector as the driver of economic growth and innovation mirrors the role of the railway industry in the 19th century, with both industries experiencing rapid expansion, attracting large-scale investment, and ultimately exposing the financial sector to significant risks. The historical parallels underscore the importance of diversification, prudent regulation, and vigilant risk management in mitigating the impact of crises emanating from dominant industries.

I hope that these links help put events surrounding the recent banking crisis in historical perspective. As always, we’ve been here before. In fact, we’ve been here a lot.

The Panic of 1866

Summary:

“It was this note posted on Overend & Gurney’s door announcing the suspension of payments that triggered the Panic of 1866. In terms of monetary policy, this panic was pivotal in the evolution of central banking. When Overend & Gurney collapsed, depositors at other banks rushed to withdraw their funds out of fear that their funds were also in danger. In response, the banks went “to the Bank of England discount office in search of funds.”

For the first time, the Bank of England acted as a Lender of Last Resort by injecting liquidity into the system, lending out £4 Million to commercial banks in just two days. The Bank of England’s actions quelled the panic and reduced its impact on the “real” economy.”

The Bank Failures and Near Failures That Started America’s Greatest Financial Panics

Why This is Relevant:

This article traces the link between long-term reputation and the impact of marquee failures on financial markets throughout history. From Jay Cooke & Co. in the 1860s to Bear Stearns and Lehman Brothers in 2008, these examples illustrate the power of reputation and how its failure can cause widespread panic in financial markets. This is especially relevant for investors today, as it is important to understand the long-term reputation of companies and the potential impacts of their failure on the wider economy. Knowing this history helps investors make more informed decisions about where to place their investments and when to be wary of market volatility. A household brand name does not guarantee safety.

Summary:

“[This paper] examines the failures or in some cases near-failures, of financial institutions that started the 12 most severe peacetime financial panics in the United States, beginning with the Panic of 1819 and ending with the Panic of 2008. The following generalizations were true in most cases, although not in all. (1) Panics were triggered by a short series of failures or near-failures; (2) many of the failing institutions were what we would now call shadow banks; (3) typically, the source of trouble was an excessive investment in real estate; and (4) typically, they had outstanding reputations for trustworthiness, prudence, and financial acumen—before they failed. It appears that in these respects the Panic of 2008 was an old-school panic.”

Bank Panics, Government Guarantees and Evidence from Free-Banking America

Why This is Relevant:

The Panic of 1854 and 1857 present us with a valuable opportunity to examine the consequences of financial and regulatory fragility. During this period, different states had different levels of regulation, which led to varied outcomes of bank failures and also to differences in trust between banks. In Indiana, the trust in the regulatory regime was particularly high, as evidenced by the fact that banks there could hold lower reserves and circulate more banknotes than their out-of-state competitors. However, the Panic of 1854 exposed a major flaw in the Indiana regulatory regime, which was that it encouraged the holding of domestic state debt to an extent unmatched in other states. This meant that when the panic hit, Indiana’s noteholders were exposed to wrong-way risk, which could not be liquidated at a price sufficient to make noteholders whole. Furthermore, markets outside of Indiana saw a decrease in banking activity after the Panic of ’57, even though these markets had no direct experience in panicked closures. This implies that the trust in the regulatory regime decreased statewide, leading to a long-lasting decline in the level of financial intermediation.

Summary:

“Governments often attempt to increase the confidence of financial market participants by making implicit or explicit guarantees of uncertain credibility. Confidence in these guarantees presumably alters the size of the financial sector, but observing the long-run consequences of failed guarantees is difficult in the modern era. We look to America’s free-banking era and compare the consequences of a broken guarantee during the Indiana-centered Panic of 1854 to the Panic of 1857 in which guarantees were honored. Our estimates of a model of endogenous market structure indicate substantial negative long-run consequences to financial depth when panics cast doubt upon a government’s ability to honor its guarantees.”

Why Didn’t the United States Establish a Central Bank until after the Panic of 1907?

Why This is Relevant:

The United States endured panic after panic in the 19th century as railways dominated an era of expansion and wealth generation. Why did it take until the Panic of 1907 for the federal government to realize a central bank was needed?

Summary:

“Monetary historians conventionally trace the establishment of the Federal Reserve System in 1913 to the turbulence of the Panic of 1907. But why did the successful movement for creating a U.S. central bank follow the Panic of 1907 and not any earlier National Banking Era panic? The 1907 panic displayed a less severe output contraction than other national banking era panics, and national bank deposit and loan data suggest only a limited impairment to intermediation through these institutions.

We argue that the Panic of 1907 was substantially different from earlier National Banking Era panics. The 1907 financial crisis focused on New York City trust companies, a relatively unregulated intermediary outside the control of the New York Clearinghouse. Yet trusts comprised a large proportion of New York City intermediary assets in 1907. Prior panics struck primarily national banks that were within the influence of the clearinghouses, and the private clearinghouses provided liquidity to member institutions that were perceived as solvent. Absent timely information on trusts, the New York Clearinghouse offered insufficient liquidity to the trust companies to quell the panic quickly.

In the aftermath of the 1907 panic, New York bankers saw heightened danger to the financial system arising from “riskier” institutions outside of their clearinghouse and beyond their direct influence. The reform proposals from New York banking interests advocated universal membership in a centralized reserve system to overcome the risk of financial panic arising from the observed isolation of some intermediaries. Serious consideration of federal legislation to reform the banking system took place because New York bankers changed in their attitude toward a system of reserves beyond their control.”