How Bank Failures Contributed to the Great Depression

On the surface, everything was hunky-dory in the summer of 1929. The total wealth of the United States had almost doubled during the Roaring Twenties, fueled, in part, by stock market speculation eagerly undertaken by a wide swath of citizens ranging from Fifth Avenue dowagers to factory workers. One Midwestern woman, a farmer, made an overnight profit of $2,000 ($31,000 in today’s dollars) betting on a car manufacturer’s stock.

When the bubble burst in spectacular fashion in October 1929, many economists, including John Kenneth Galbraith, author of The Great Crash 1929, blamed the worldwide, decade-long Great Depression that followed on all those reckless speculators. Most saw the banks as victims, not culprits.

The reality is more complex. Sure, without all that uncontrolled and irrational market speculation, the 1930s might be recalled simply as a period when the economy and prosperity stalled. But just why—and how—could those gamblers dominate the stock market? And why did a crisis in the markets become a systemic decade-long economic catastrophe during which unemployment skyrocketed to 25 percent and the cost of goods and services plunged? By 1933, dozen eggs cost only 13 cents, down from 50 cents in 1929. Banks failed—between a third and half of all U.S. financial institutions collapsed, wiping out the lifetime savings of millions of Americans.

The familiar narrative of the Great Depression places banks among the institutions that suffered fallout from the crisis. In fact, in the eyes of such luminaries as Ben Bernanke, an economic historian and former head of the Federal Reserve, the crisis was all about the banks—from the central bank (the Fed itself), down to the smallest savings institutions. “Regarding the Great Depression…we did it,” Bernanke said in a 2002 speech, referring primarily to the Fed’s role. “We’re sorry.”

Here are four ways banks “did it”:

Banks Extended Too Much Credit

The runaway speculation that triggered the 1929 crash and the Great Depression that followed couldn’t have taken place without the banks, which fueled the 1920s credit boom. New businesses—making new products like automobiles, radios and refrigerators—borrowed to support non-stop expansion in output. They kept borrowing and spending even as business inventories soared (300 percent between 1928 and 1929 alone) and Americans’ wages stagnated. The banks, ignoring the warnings signs, kept subsidizing them.

The banks also funded the speculation itself, providing the money that individual investors needed to buy stocks on margin. That Midwestern farmer might have borrowed up to 90 percent of the money she needed to make her overnight killing on the automobile stock, financed by her local bank. Bank lenders discounted or downplayed growing signs that Americans were overstretched. Farm incomes, in particular, plunged in the years leading up to 1929, and others found their wages stagnant. Their prosperity came solely from their stock market wealth—which didn’t last.

People gathering in front of the New York Stock Exchange on October 29, 1929, checking the hysterical shrinkage of stock market prices.

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Banks Ignored the Federal Reserve

The Fed, which serves as America’s central bank, did try to rein things in, albeit too slowly and too late in the game. It sent warning letters to the banks to which the Fed itself provided credit, warning them to take their collective feet off the gas pedals. Banks, with their eyes firmly fixed on the “easy” profits to be earned by funding speculation, paid little attention. After all, wasn’t it a virtuous cycle? The more investment profits their customers generated, the more money they would have to spend on new homes or consumer goods. Why worry? By the time the Fed slammed on the brakes by raising interest rates in 1929, it was too late to stem the crash, or the fallout on the banks.

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Banks Didn’t Maintain Adequate Reserves

It sounds kind of geeky, but one of the ways that banks contribute to the health of the economy—and help avoid catastrophes like the Great Depression—is to manage their cash reserves. Typically, banks hold onto only a small percentage of all the money depositors entrust to them, and lend out the rest in search of a profit; that’s how they make their money. In ordinary times, banks count on the ability to borrow from other financial institutions, or from the Federal Reserve, to cover any unexpected shortfall in reserves if their customers start showing up in droves and demanding their deposits back. During the Depression, the pressure on those backup providers of capital proved unsustainable; moreover, large numbers of American banks hadn’t joined the Federal Reserve system and so weren’t able to tap its reserves to avoid collapse.

It wasn’t until the stock market crashed and fearful Americans flocked to banks to demand their cash—so they could stow it under the mattress or use it to offset their massive stock market losses—that banks realized what they’d done. They hadn’t kept enough reserves on hand to address the growing risks associated with runaway credit and speculation.

Ironically, once banks started to try to correct their missteps, they made the problem worse. When banks sought to protect themselves, they stopped lending money. Businesses couldn’t get access to capital, and closed their doors, throwing millions of Americans out of work. Those unemployed Americans couldn’t keep spending, and the toxic downward spiral continued. As bank after bank collapsed, it wasn’t just savings that were lost, but information: Surviving institutions had no way to gauge which companies or individuals were good credit risks.

Shipment of gold coins, valued into six figures at the time, arriving from the depositors of the Empire Trust Co. It was part of the stream flowed back into the coffers of the Federal Reserve Bank during the stock market crisis.

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Banks Needed Fixing

If banks led to the crash and the subsequent economic crisis that extended into the Great Depression, then they needed to be fixed in order for the economy to begin to recover. By 1933, the wave of bank failures was stemmed by the decision of the newly elected president, Franklin D. Roosevelt, to declare a four-day banking “holiday” while Congress debated and passed the Emergency Banking Act, which formed the basis of the 1933 Banking Act, or Glass-Steagall Act. For their part, legislators required banks to join the Federal Reserve system and approved the creation of deposit insurance, so that future bank failures couldn’t wreak havoc on family savings. They also took steps to curb speculation by banning commercial lenders from dabbling in the stock market. Even before Roosevelt signed the new measures into law, Americans began returning hoarded cash to surviving banks. The banking system had been saved, even though it would take years for the economy itself to climb out of the deep hole of the Depression.