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

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.