Ashcraft, Adam B.
Working Paper
Are banks really special? New evidence from the
FDIC-induced failure of healthy banks
Staff Report, No. 176
Provided in Cooperation with:
Federal Reserve Bank of New York
Suggested Citation: Ashcraft, Adam B. (2003) : Are banks really special? New evidence from
the FDIC-induced failure of healthy banks, Staff Report, No. 176, Federal Reserve Bank of New
York, New York, NY
This Version is available at:
http://hdl.handle.net/10419/60604
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Federal Reserve Bank of New York
Staff Reports
Are Banks Really Special?
New Evidence from the FDIC-Induced Failure of Healthy Banks
Adam B. Ashcraft
Staff Report no. 176
December 2003
This paper presents preliminary findings and is being distributed to economists
and other interested readers solely to stimulate discussion and elicit comments.
The views expressed in the paper are those of the author and are not necessarily
reflective of views at the Federal Reserve Bank of New York or the Federal
Reserve System. Any errors or omissions are the responsibility of the author.
Are Banks Really Special? New Evidence from the FDIC-Induced Failure of Healthy
Banks
Adam B. Ashcraft
Federal Reserve Bank of New York Staff Reports, no. 176
December 2003
JEL classification: E5, G18, G33
Abstract
The FDIC used cross-guarantees to close thirty-eight subsidiaries of First RepublicBank
Corporation in 1988 and eighteen subsidiaries of First City Bancorporation in 1992 when
lead banks from each of these Texas-based bank holding companies were declared
insolvent. I use this exogenous failure of otherwise healthy subsidiary banks as a natural
experiment for studying the impact of bank failure on local-area real economic activity. I
find that the closings of the subsidiaries were associated with a significant decline in bank
lending that led to a permanent reduction in real county income of about 3 percent.
Key words: bank failures, cross-guarantee, uniqueness of banks
*Research and Market Analysis Group, Federal Reserve Bank of New York, New York,
N.Y. 10045 (e-mail: adam.ashcraft@ny.frb.org). The author thanks Jonathan Guryan,
Hoyt Bleakley, and participants at the University of Chicago GSB Macro lunch, the Federal
Reserve System Fall 2003 Banking Conference, and the Federal Reserve Bank of New York
Banking Studies lunch for their constructive comments. He also thanks Chris Metli and Sam
Hansen for their excellent research assistance. The views expressed in the paper are those of
the author and do not necessarily reflect the position of the Federal Reserve Bank of New
York or the Federal Reserve System.
1. Introduction
Why are banks so highly-regulated? There are probably several reasons, but one of the more
important is a belief that bank failures are costly. While the most direct mechanism through
which failures affect real economic activity is the loss of real wealth by parties holding bank
liabilities and equity, even the parties that do not lose wealth suffer from illiquidity while they
wait for assets to be liquidated. In the presence of borrowing constraints, this illiquidity
affects real spending. Bank failures also disrupt or destroy long-standing credit relationships
between a bank and its borrowers. If customers are unable to replace these relationships
with other lenders on equal terms, this contraction in the supply of bank credit can also have
an effect on real activity.
Bernanke (1983) first highlighted the role that the financial system played in amplifying other
shocks during the Great Depression, emphasizing the effect that weak firm balance sheets
and bank failures had in contracting the supply of credit. He documents the severe
contraction in bank lending in the early 1930s, and develops evidence that failed bank
deposits have marginal explanatory power over and above monetary aggregates in explaining
industrial production.
1
More recently, Calomiris and Mason (2003) use an instrumental
variables strategy with panel data in order to identify loan supply shocks and their effect on
local area income over 1930-1932. The authors estimate an elasticity of real state income
1
This view is not uncontested. It is not immediately clear that the observed contraction in bank lending was actually
driven by bank failures, as it could reasonably have been caused by a decline in loan demand related depressed business
conditions or a prompted by a deflation-induced deterioration in firm creditworthiness. Rockoff (1993) argues that the
more important effect of bank failures is the illiquidity of suspended deposits. When using a quality-adjusted measure of
the money supply, Rockoff determines that non-monetary variables are not necessary to explain the severity of the
downturn.
1
growth to bank loan supply growth of 45 percent, where a one standard deviation decrease
in loan growth over three years (17.9 percent) reduces output growth over three years by
about 7 percentage points.
2
While the existing literature suggests that bank failures were important during the 1930s, this
paper addresses the question of whether or not bank failures still matter. The answer to this
question is not obvious for at least three reasons. First, the creation of deposit insurance has
significantly reduced the negative wealth effect of failures directly for depositors and
indirectly for equity holders as the under-pricing of deposit insurance induced banks to
increase leverage. Second, establishing the FDIC as receiver has minimized the illiquidity of
failed bank deposits, as well as the claims of other creditors, and shortened the overall
contraction in loan supply. Finally, the U.S. economy has likely become less bank dependent
since the 1930s. In particular, Ashcraft (2003) estimates that the elasticity of real state
income to bank loan supply is close to zero, and is definitely no larger than 10 percent.
Together, these three changes in the financial system raise the question of whether or not
bank failures still matter.
This question takes on greater relevance as a recent empirical literature has struggled to
establish a convincing connection between bank failures and local area economic activity. In
a study of rural counties in Kansas, Nebraska, and Oklahoma over 1981-1986, Gilbert and
Kochin (1989) find weak evidence that bank failures are followed by a decline in economic
2
Anari, Kolari, and Mason (2003) separately conclude that the stock of suspended deposits is as important as money stock
in explaining output change over forecast horizons of one to three years during the 1930s. It follows that both the
illiquidity of suspended deposits and the contraction in lending played an important role.
