The Effect of Bank Failures on Economic Activity: Evidence from U.S. States in the Early 20th Century


  • This paper has benefited greatly from the comments of Howard Bodenhorn, Fred Carns, Graham Elliot, Mark Flannery, Christopher Kurz, Joe Mason, Arthur Murton, Dan Nuxoll, Matthew Spiegel, Haluk Unal, Jesse Weiher, and Eugene White, as well as participants at Federal Deposit Insurance Corporation seminars, the Rutgers University Economic History Seminar, the 2006 ASSA meetings, the Federal Reserve Bank of Chicago Banking Conference, and the 2005 Washington Area Finance Association meetings. We are especially grateful to Paul Kupiec, two anonymous referees, and the editor for very detailed comments and useful suggestions. We thank Kris Mitchener for providing us his farm bankruptcy data and Richard Grossman for providing us with the minimum capital requirement data. Ramirez gratefully acknowledges the financial support from the Center for Financial Research at the Federal Deposit Insurance Corporation. The views expressed in this article do not necessarily reflect those of the Federal Deposit Insurance Corporation.


This paper provides evidence documenting the existence of a “bank failure channel”—the magnifying effect of bank failures on economic distress—using state-level quarterly time series from 1900q1 to 1929q4. We estimate a vector autoregression model of bank failures for each state. The forecast-error variance decompositions are used to construct a categorical measure of the “bank failure channel.” We examine the influence of regulatory variables, economic conditions, and banking conditions on the degree to which bank failures propagate distress. State-sponsored deposit insurance and minimum capital requirements are important for explaining the likelihood of having a bank failure channel.