Establishing the Fed worsened the Great Depression – St Louis Fed paper

Establishing the Federal Reserve weakened the incentives for banks to guard against systemic risk and worsened the Great Depression, a research paper published by the St Louis Fed argues.

“Systemically important banks acted as though they expected the Fed to provide liquidity risk insurance that had not existed before the Fed’s founding,”  write Charles Calomiris, Matthew Jamerski and David Wheelock.

The authors use data on interbank connections and bank balance sheets from 1910–29 to examine how connections among banks affect liquidity risk. Using their findings they also test the effect establishing the Fed had on banks’ management of capital buffers.

The researchers find the interbank deposit system encouraged banks to increase capital ratios, while more networked relationships led them to hold lower capital ratios. This was because they could more easily borrow funds when needed, the authors say.

The authors find that before the Fed was established, individual bank capital ratios varied according to the number of their inter-bank deposits and how well networked they were. After the Fed was established, these factors had “much less impact”, the authors find, suggesting that banks no longer perceived a need to hold extra capital against systemic risk.

They conclude the reduced prudence among banks due to the creation of a lender of last resort likely contributed to the system’s vulnerability to contagion and worsened the Depression.