The year 2018 marked the passing of a decade since the lowest point of the financial crisis. Observers of the financial industry rehashed the various narratives of the crisis as part of a burst of anniversary commemorations. The dominant narrative about the policy response to the crisis (although not necessarily the most accurate or fact-based one) is what might be called the standard narrative: the interventions of the financial authorities during 2008 and 2009 likely saved us from another Great Depression. There are variants of this standard narrative, but most of its adherents believe that either the response (consisting of bailouts and massive financial support) was measured and effective, or else the authorities should have been even more aggressive in their interventions.

This book, Fighting Financial Crises by economists Gary Gorton and Ellis Tallman, supports the latter version of the standard narrative. Interestingly, the book liberally cites fellow standard narrative advocates Ben Bernanke and Timothy Geithner, who were the chief architects of the U.S. response. Bernanke even provided a blurb for the book’s jacket cover.

Gorton is a professor at the Yale School of Management and is widely known for advancing the argument that the financial crisis was a “run on the repo market.” He was also an adviser during the crisis to American Insurance Group, which was one of the largest government bailout recipients during the crisis. Tallman is the director of research at the Federal Reserve Bank of Cleveland and is known for his work on the history of banking panics and liquidity lending during financial crises.

The premise of Fighting Financial Crises is that, consistent with the authors’ prior research, there is a “plug and chug” formula for responding to financial crises. Whether we look at the panics of the Gilded Age or the recent crisis, this formula requires that the financial authorities need only do some basic research to determine the appropriate policy response to the crisis. Specifically, they need to:

  • Find the short-term debt causing the instability (run).
  • Suppress individual institution financial information.
  • Open emergency lending facilities.
  • Prevent systemic (too-big-to-fail) institutions from failing by bailing them out.
  • Circumvent any laws and regulations that stand in the way of this response.

Panics and bailouts of the 19th century / The authors open the book with a deep dive into the National Bank panics of the Gilded Age. They divide these into more severe panics (1873, 1893, and 1907) and less severe panics (1884, 1890, 1896, 1914) in order to judge the prudence of interventions in each panic. Disappointingly, the authors do not explain clearly what distinguishes the more severe from the less severe panics and the comparative data Gorton and Tallman provide do not clearly support such a classification.

The authors then shift to a detailed discussion of the New York Clearing House Association (NYCHA), its history, and what tools it used to fight panics. The NYCHA was a privately organized association, modeled after a counterpart in London, through which the New York banks would “settle their accounts with each other and make or receive payment of balances and to ‘clear’ the transactions of the day for which the settlement is made.” It also conducted periodic bank examinations of its members to assess the risk the individual banks posed to the clearinghouse members: “Each member has a direct interest in every other, for it does not wish to run the risk of loss in giving credit to checks of an insolvent institution.” Special examinations, which were more targeted, were triggered by rumors of weakness. If a bank did not follow the recommendations incorporated into an examination report, it could be suspended or expelled from NYCHA membership. As Gorton and Tallman describe it, the function of the NYCHA was akin to a “regulatory and central-bank-like role.”

In the early stages of a panic, the NYCHA’s supportive response involved three actions:

  • issuance of clearinghouse loan certificates, which were short-term, collateralized loans “effectively guaranteed by the clearinghouse membership jointly”;
  • bailouts of too-big-to-fail institutions; and
  • suppression of financial information of individual institutions.

In their chapter “Too Big to Fail Before the Fed,” which is also the name of a National Bureau of Economic Research paper they released in March 2016, Gorton and Tallman make the case that the megabank bailouts of the past 35 years had their origins in similar bailouts through the NYCHA during the 19th century.

The chapter starts off with a direct attack on the “moral hazard” argument against bailouts:

Banks have allegedly engaged in taking risks greater than they otherwise would because of a belief that they would be bailed out by the government, possibly causing or contributing to the financial crisis of 2007–8, because large banks believe they are too big to fail. … In the modern era it has been hard to find evidence that large banks are the beneficiaries of implicit too-big-to-fail government policies and become riskier as a result.

The chapter then walks through case studies of how and why it made economic sense for the member banks of the NYCHA to support too-big-to-fail institutions during the panics of the 1800s:

Because a private-market coalition of banking institutions took these actions, it strongly suggests that a too-big-to-fail practice or policy per se (and the associated “moral hazard” problem of exacerbating bank risk taking) is not the problem causing crises…. In the pre-Fed era, bailing out large, interconnected banks was a reasonable response to the vulnerability of short-term debt to runs that could unnecessarily threaten large banks and thereby the entire banking system.

MNB / To support their case, the authors set out statistics for the 12 outright bank failures and five “bank assistance transactions” in New York City from 1864 to the creation of the Fed in 1913. Gorton and Tallman choose a case study of a bailout by the NYCHA of Metropolitan National Bank (MNB) in 1884. MNB was double the size of the average clearinghouse bank and was quite interconnected based on the data the authors reference: “Had the clearinghouse not acted with admirable promptness in coming to its assistance, there is little question that out-of-town banks would have become alarmed for their deposits, not only in this bank but for those in the banks generally.” A bailout of $6 million was extended by the NYCHA to MNB: “Private-market participants were therefore acutely aware that their actions were effectively a bailout of the stricken bank. The benefit was the prevention of banking panic on a wider scale.” MNB ultimately failed outright several months later, after the panic subsided.

Gorton and Tallman state that the bailout of MNB does “align closely to our view of proper responses to fight financial crises.” There were questions of the bank’s solvency, as there often are during crises. The bank had a high degree of interconnectedness, there was a risk of losses to clearinghouse members as a result of the bailout, and the implication is that MNB was “systemically important.” The authors go on to make an analogy to the bailouts of the 2000s crisis, claiming MNB was “a model for an orderly resolution.” The authors contrast MNB with the NYCHA’s decision during the Panic of 1907 to allow Knickerbocker Trust to fail, which they argue “led to the most severe period of the financial crisis of 1907, and likely the ramifications of that failure contributed largely to that distress.”

Conclusion / Gorton and Tallman’s historical details of the panics of the 1800s for the New York banks at the epicenter of the financial system are unequaled, based on my research. The authors have taken stories from the contemporary New York press and employed available financial data from bank reports to develop a narrative and accompanying tables that bring to life the panics of that era. These details alone make the book worthy of a place on any financial historian’s bookshelf.

Where their effort falls short is in the policy conclusions they draw from those details. I’m not convinced by their arguments justifying the public sector bailouts that have become so familiar in the past century. There is an enormous difference between a voluntary organization of bankers like the NYCHA bailing out an institution based on their own financial interests and the case where government authorities use public funds to bail out politically connected institutions.

As for Gorton and Tallman’s consideration of moral hazard, if you look at a too-big-to-fail bank with a long history, e.g., Citi, you find that during the Gilded Age it was a rock-solid bank that absorbed weaker institutions during panics. Since the creation of the Fed and the proliferation of government bailouts in the last century, Citi has now morphed into a perpetual ward of the state. This would have been a good moral hazard case study for Gorton and Tallman to consider. Unfortunately, it seems they already had their chosen narrative and stuck to it.