Why Banks Failed in 1931
The FINANCIAL COUNSELOR
by CHARLES F. SPEARE
THE reasons why banks fail are of less concern to embarrassed depositors than the fact that they do fail, bringing suffering to thousands of individuals and business stagnation to scores of communities. In the ten years from 1920 to 1929 inclusive, approximately 5000 national, state, and private banks in the United States were placed in the hands of receivers. Since then about 3200 more have been added to this number, the momentum of failures reaching its height in October 1931, when, in one month, no less than 512 institutions, with liabilities of $566,000,000, closed their doors. In the first ten months of 1931 the total liabilities of defunct banks amounted to about $1,400,000,000, which was almost $200,000,000 more than the record for the previous thirty-six months.
What has been the cause of this high mortality rate among the banks in recent years, and what particularly has brought about the alarming increase in insolvencies since October 1930?
In normal times a few bank failures can be traced to incompetent management or to the dishonesty of officers or directors, but most of the ‘normal’ failures are the result of local depressions, usually agricultural or industrial in character. In 1930, however, which was not a normal year, the primary cause of failures was a shrinkage in real-estate values, both in urban and in farming communities, particularly in those sections which had enjoyed a boom in property values between 1921 and 1926. Thus the greatest sufferers in 1930 were depositors in Arkansas, Georgia, Florida, and the Dakotas, and to some extent in Illinois, Iowa, Indiana, anti Missouri. In that year there were less than a dozen bank failures in New York and New Jersey, and practically none in New England.
In 1931, however, new causes began to operate as panic among depositors moved East from the South and West. The seat of ‘infection’ shifted to the industrial and commercial centres, and mortalities were greatest in metropolitan areas like Chicago, Philadelphia, Pittsburgh, and Toledo. In New York and New Jersey there were four times as many suspensions as in the year before, and 122 in Pennsylvania compared with 19 the previous year. New England, however, still displayed the greatest immunity of any geographical section, with three of her six states showing a clear record and the others a total of only seven failures, up to October, as compared with 190 in the Middle Atlantic states.
The outstanding feature of the present depression is the enormous depreciation that has taken place in the value of securities. Since October 1930, New York Stock Exchange bonds alone have shrunk $7,000,000,000. In the twelve months prior to October 1931, railroad bonds, of the type that forms the largest proportion of the security holdings of banks, declined from 30 to 50 per cent. The dollar bonds of South American and continental European borrowers which were most in vogue among banks fell from 50 to 75 per cent, and a number of them defaulted on their interest. Some of the unlisted bonds of public utility holding companies suffered almost as much. Popular New York bank stocks, which were liberally sprinkled through the investment portfolios of state banks and trust companies, declined 60 to 80 per cent.
To show how the shrinkage in security values has affected the banks, let us take for illustration a typical country bank with a capital of $100,000, surplus of $100,000, and undivided profits of $100,000. Its deposits, say, were $2,500,000, which is a legitimate ratio to its financial structure. It might reasonably invest from $1,000,000 to $1,500,000 in securities. Even if half of this amount conformed to the recent rule adopted by the Federal Reserve authorities, that BONDS of a certain rating may be carried at cost and not ‘at market,’ this would still leave $750,000 subject to the market trend. An average depreciation of from 25 to 30 per cent in this portion of tho bank’s investments would wipe out surplus and undivided profits of $200,000 and impair the bank’s capital. When such impairment occurs, it must be corrected at once or the bank will be taken into the control of the national or stale banking authorities. This is precisely what happened time and again during the past year.
In some instances when an important institution became embarrassed, say in Philadelphia or Chicago, fear communicated itself to the depositors of smaller banks in the neighborhood. Runs developed, bringing about a steady seepage of deposits, which the banks could meet only by selling securities. This forced selling throughout the summer and early autumn of 1931 threw the bond market into a panic. Prices dropped still lower, with the result that many institutions which had not been compelled to sell their securities had to go into the hands of receivers. To the surprise of their customers, such banks went down while holding the bulk of their deposits intact. Never before have these conditions been met with in this country.
It may be proper to ask why the banks held such a high proportion of securities subject to violent fluctuations which threatened them with insolvency whenever the bond and stock market took a sharp dip. One answer is that the whole trend of banking has changed in the last decade. Smaller banks have not been able to obtain their former proportion of local commercial loans or of good nationally known commercial paper. There has been a country-wide competition for gross deposits. Many banks have increased their overhead by taking on foolish and unprofitable services. They have paid higher interest rates on deposits than they were warranted in paying.
All this has compelled banks to seek investments yielding the maximum return. Ordinarily these are the very ones which are weakest structurally and suffer most when times are bad. Then, too, the country banker has been imposed on by the city bond salesman. Frequently he has not had the slightest idea of the intrinsic value of what he was buying. His error was in trying to get too much for his money. The appalling total of failures in the banking world during the past two years has been the heavy penalty he has paid for his poor judgment.
Of course there were some bank failures in 1931 caused by depreciation in urban real estate and in farm lands, as well as by the decline in commodities. Some were brought about by dishonest management, others by poor local commercial loans. The principal cause, however, and the only one which will explain the frequency and size of recent failures, was the shrinkage in security values. It is significant that, with the improvement in security prices early in November, the number of bank suspensions tapered off sharply. This reflected the immediate change in sentiment that developed with the formation and functioning of the $500,000,000 National Credit Corporation — an emergency institution set up at the suggestion of President Hoover to assist weak banks during the financial crisis.