The Founding of the Federal Reserve, the Great Depression and the Evolution of the U.S. Interbank Network

Interesting paper by Matthew Jaremski and David C. Wheelock:

Financial network structure is an important determinant of systemic risk. This paper examines how the establishment of the Federal Reserve and Great Depression affected U.S. interbank network structure. Seeking liquidity sources, banks generally preferred to connect to Federal Reserve member banks in cities with Fed offices or clearinghouses. Overall network concentration declined initially as banks connected to Federal Reserve cities other than New York, but increased in the Depression. Banks that survived the Depression generally had higher percentages of connections to Federal Reserve cities and to correspondent banks that also survived.

More specifically, Federal Reserve was key to Depression in many ways:

The Federal Reserve was intended to reduce the banking system’s reliance on the interbank network, and especially the concentration of the system’s reserves in New York City. Although the share of interbank deposits held by major New York City banks did fall after the Fed was established, previous studies have not examined how the interbank network changed with the introduction of the Fed. Using newly digitized data on the interbank relationships of every U.S. depository institutions in 1900, 1910, 1919, 1929 and 1940, we quantify changes in network concentration and other aspects of network structure over four decades.

We show that while the banks most central to the network remained those located in New York City and other major centers, the regional Federal Reserve cities took on a more important role in the network after the Fed was established and again during the Great Depression. Ironically, by pushing the
network toward the regional Fed cities, the System’s founders may have inadvertently made the banking system more vulnerable to regional liquidity shocks and to the responsiveness of local Federal Reserve Bank officials to those events.17

Interbank connections were a conduit for bank distress during the Great Depression. Banks with correspondents that failed or otherwise closed were themselves more likely to close during the Depression. Banks apparently responded to the Depression by linking even more to correspondents in cities with Federal Reserve offices, especially to banks in New York City, which saw a relative increase in correspondent links between 1929 and 1940. Thus, while the establishment of the Federal Reserve altered the structure of the interbank network, the Fed’s presence neither eliminated the network nor prevent it from transmitting shocks across the banking system. Moreover, the amplification of distress through the network in turn contributed to events that further altered the network’s structure while at the same time having even more profound long-term impacts on the regulation of the U.S. banking system.




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