Like a spinning and skipping broken record, our history has been filled with an endless number of banking crises. And unfortunately, the financial crisis of 2008-2009 will not be our last (read more about rhyming history). Robert F. Bruner, professor and Dean at the Darden Graduate School of Business Administration, has studied the repetitive nature of banking crises and identified core foundational aspects present in these vicious financial events.
In a period spanning 105 years (1900 – 2005), Bruner references 31 separate crises occurring across the world in various countries. Just in the last handful of decades, Americans have experienced the seizure of the Continental Illinois National Bank and Trust Company (1984), the S&L crisis (Savings & Loan – late 1980s), the disintegration of Long-Term Capital Management (1998), followed by the recent falling of dominoes in the first decade of the 21st Century (Bear Stearns, Lehman Brothers, Wamu, AIG, etc.). What do many of these crises have in common?
In comparing the recent global financial crisis, Bruner compares the recent events to the “Panic of 1907” – the last financial crisis before the creation of the Federal Reserve System in 1913. The last few years have been rough, but a century ago San Franciscans endured the mother of all crises. This is how Bruner described the time period:
“The San Francisco earthquake of 18 April 1906 triggered a massive call on global gold reserves and a liquidity crunch in the United States. A recession commenced in June 1907. Security prices declined. In September, New York City narrowly averted a failure to refinance outstanding bonds. Then, on 16 October, a “bear squeeze” speculation failed and rendered two brokerage firms insolvent. The next day, depositors began a run on Knickerbocker Trust Company…Runs spread to other trust companies and banks in New York City. And the panic rippled across the United States.”
Bruner highlights four key factors inherent in these, and other, financial crises. Here is a summary of the four elements:
Existence of Systemic Structure: In order for a crisis to occur, an economy needs a collection of linked financial intermediaries to form a system. Throughout history, transactions and deposits have connected to multiple systems around the globe.
Systemic Instability: Hyman Minsk, a renowned 20th Century economist, was known for his thoughts on his “Financial Instability Hypothesis.” At the core of Minsky’s crisis beliefs was the idea that economic slumps were caused by the credit cycle. At the late stages of an economic cycle there is a larger appetite to assume additional risk and debt. A spiraling vortex can occur as “Easy credit amplifies the boom, and tight credit amplifies the contraction,” Minsky states.
Systemic Shock: Beyond an unstable system, a crisis needs a spark. For Bruner that spark must have four characteristics:
- Real, Not Apparent: The shock must be “real, not apparent.” The disturbance must be disruptive enough to shake the trust of the financial system and be large enough to have a real economic impact (e.g., new technologies, massive labor strike, deregulation, or even an earthquake).
- Large: The trigger of a financial crisis must be large enough to shift the outlook of investors.
- Unambiguous and Difficult to Repeat: The shock must unambiguously stand out from the standard marketplace news.
- Surprising: The event must be unanticipated and cause a shift in thinking.
Response and Intervention: Effectively, the response to a shock converts an overconfident boom into fear and pessimism. The reply can often be an overreaction to the existing fundamentals, which flies in the face of efficient markets and rational decision making.
According to Bruner, crises including the one triggered by the earthquake of 1906 carry the four previously mentioned elements.
Solution = Leadership
At the vortex of any financial crisis lies fear and panic, which require leadership to mitigate the damage. John Pierpont “J.P.” Morgan, semi-retired banking executive, orchestrated leadership in 1907 by organizing a rescue of “trust companies, banks, the New York Stock Exchange, New York City, and the brokerage firm of Moore and Schley.”
Time will tell and history will judge whether Federal Reserve Chairman Ben Bernanke and Treasury Secretaries Hank Paulson and Timothy Geithner provided the necessary leadership to sustainably lead us out of the financial crisis. Of course, decisions made by the key U.S. leadership figures are not made in a vacuum, so choices made by our international brethren can impact the success of our monetary and fiscal policies too.
There have been 18 substantial global bank crises since World War II and the recent credit-induced collapse will not be the last as long as Bruner’s four elements of a crisis exist (structure, instability, shock, and intervention). The ultimate outcome of a crisis will be dependent on the nature of leadership, coordinated government intervention, and regulation. The global economic record will continue spinning, but with Robert Bruner’s lessons learned from the Panic of 1907, hopefully the music will last for a very long time before skipping on a crisis again.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and a derivative security of an AIG insurance subsidiary, but at time of publishing had no direct positions in JPM.