Information Production and Suppression

Three were very serious events. So we can study the experience of multiple panics occurring in the same system. Of course, many casually dismiss the past as irrelevant, but how else do we learn if not from history? With respect to fi nancial crises, it really is, as Marx put it, a case where “History repeats itself, fi rst as tragedy, second as farce.” The reality is that fi nancial crises have occurred throughout the history of market economies. There is a common root problem: short- term debt. Short- term debt is necessary for the economy to work, but it is vulnerable to runs. This is clearest to see during the National Banking Era.

Second, this period is particularly interesting because there was no deposit insurance and no central bank, and so expectations of possible future central bank interventions during a crisis are not an issue. During modern crises, fi rms and households expect the central bank or government ( Treasury) to intervene by, for example, issuing blanket guarantees against bank debt, nationalizing the banks, bailing out banks, and so on. In most modern crises, there are bank runs, but they come later in the sequence of events than we observe in the earlier period, as people often wait to see what is going to happen. This makes modern crises very diffi cult to study. Because of the public’s expectations about interventions, some conclude that the interventions themselves are the problem. And further, because delays in actions by authorities can take place earlier or later in the event sequence, it may appear that crisis events have nothing in common. In that circumstance, researchers and regulators seize on idiosyncratic aspects of each crisis and miss the essential common features.

Third, crises typically do not happen frequently enough for there to be a learning process about how to fi ght them or to develop some clarity about the nature of a fi nancial crisis. Lessons from fi ghting previous crises are lost. Without multiple observations, crises are attributed to all sorts of factors. That’s why Bagehot is still invoked. Our view is that by studying a period that avoids these modern complications but exhibits the same short- term debt problems, we can distill the essence of fi ghting crises. We can state some common principles or guidelines for fi ghting crises. And it is important to note that crises during the National Banking Era cannot be due to “moral hazard” or “too big to fail,” so some clarity about the underlying cause of a fi nancial crisis can be gleaned.

During the crises of the US National Banking Era, banks would suspend convertibility of deposits into cash, that is, banks would refuse to repay amounts in depositors’ checking accounts. Suspension was an intervention meant to disrupt widespread liquidity drains from the banking system. Suspension was always illegal, but it was tolerated as necessary to save the bank-

ing system (a lesson that was lost and could not be recovered during 2007– 8). We study how depositors’ beliefs change during the period of the suspension of convertibility— as a laboratory to uncover what caused the change in depositor sentiment.

Prior to the Federal Reserve System and without deposit insurance, people in the United States could rely only on private bank clearinghouses to fi ght crises. Among those institutions, we focus on the New York City Clearing House Association, an organization of private banks. New York City had become the key fi nancial center of the United States by the mid- 1860s, and by that time, the New York Clearing House was at the center of the US banking system during the National Banking Era. The clearinghouse also was the leader in fi ghting banking panics prior to the existence of the Federal Reserve System (the central bank). It is instructive to study the period before the Federal Reserve was in existence because we will see that the clearinghouse engaged in many of the actions that central banks engage in today to fi ght crises. We will seek to understand these actions and why they are successful in the fi ght against a crisis.

The Federal Reserve System was, to a large extent, modeled after the New York Clearing House and the existing clearinghouse system across the country (as well as the Bank of England). With regard to liquidity provision, an essential innovation of the Federal Reserve System was the establishment of a permanent discount window, one that was open all the time, where member banks could borrow money by depositing collateral. The Federal Reserve’s discount window was always available, whereas the clearinghouses’ emergency lending facilities were open and functioning only during banking panics. The panic had to happen fi rst in the clearinghouse case, whereas it was hoped that with the Federal Reserve’s permanent discount window perhaps the panic could be avoided.

But there was something else that the Federal Reserve System learned and retained from the history of private bank clearinghouses: secrecy about the identities of the banks borrowing from the discount window and management of the information environment more generally. This is a hallmark of fi ghting crises. During the most severe crises, the pre– Federal Reserve clearinghouse actions were similar to those of modern central banks— for example, bank- specifi c information is suppressed rather than made public and only limited aggregate information is released. Keeping information suppressed helps restore confi dence, especially if the information might reveal what could be temporary weakness among a few banks.

During the 2007– 8 fi nancial crisis, the government (Federal Reserve Sys tem, US Treasury, and the Securities and Exchange Commission [SEC])

adopted fi ve policy responses. First, new anonymous short- term (or temporary) lending programs were put into place, including the Term Auction Facility, the Term Securities Lending Facility, and the Primary Dealer Credit Facility. These programs were designed to make loans in secret, protecting the anonymity of borrowers in order to avoid identifying weak banks, which might then face runs. The Federal Reserve’s discount window is regarded as being unable to maintain the secrecy of borrower identity. Borrowers become stigmatized if their name is revealed.1 Second, in an attempt to prevent revelation of weak fi nancial institutions, the SEC instituted short- sale bans on the stock of 797 fi nancial fi rms starting on September 18, 2008.2 Third, the Federal Reserve conducted stress tests on large banks and publicly summarized the results with the amount of new capital each bank needed to raise.3 Fourth, some fi nancial institutions were effectively bailed out, notably the investment bank Bear Stearns and the insurance company American International Group (AIG). And fi fth, the Federal Reserve lowered the policy rate to near zero. These policies together with the Troubled Asset Relief Program appear to have been successful in avoiding another depression.

During a severe banking panic, the clearinghouse engaged in policies analogous to the fi rst four policy responses mentioned above. First, there was anonymous temporary lending via clearinghouse loan certifi cates, which were ultimately the joint liabilities of the clearinghouse members and came into existence only during panics. Member banks could deposit specifi ed collateral with a clearinghouse committee and receive loan certifi cates that could be used in the clearing process and in later panics were also handed out to the public in small denominations (from clearinghouses other than the New York Clearing House). The borrowing amounts of each bank were typically kept secret. In addition, the clearinghouse suppressed their normal requirement that member banks release balance sheet information to the press each week. Like the short- sale constraints, this suppression of information avoided revealing weak banks. The clearinghouse also conducted special examinations of banks during the suspension period (similar to the stress tests) and then announced publicly only that the bank was solvent; no details were supplied. Finally, the clearinghouse effectively organized (and funded) depositor bailouts of member banks. The clearinghouse’s management of the crisis reestablished confi dence in the banking system.

The panics that we will study are listed in table 1.1, which shows the National Bureau of Economic Research (NBER) recession dates, peak to trough. The shaded recessions were recessions that had a banking panic where the “panic date” is the date that the New York Clearing House authorized the issuance of clearinghouse loan certifi cates. The major panics were those of

table 1.1. National Banking Era panics

NBER business cycle dates, peak– trough Panic date %∆(C/D) %∆(pig iron) Loss per deposit $ % and # of US national bank failures

Oct. 1873– Mar. 1879 Sept. 1873 14.53 −51.0 0.021 2.8 (56) Mar. 1882– May 1885 June 1884 8.8 −14.0 0.008 0.9 (10) Mar. 1887– Apr. 1888 No panic 3.0 −9.0 0.005 0.4 (12) July 1890– May 1891 Nov. 1890 9.0 −34.0 0.001 0.4 (14) Jan. 1893– June 1894 May 1893 16.0 −29.0 0.017 1.9 (74) Dec. 1895– June 1897 Oct. 1896 14.3 −4.0 0.012 1.6 (60) June 1899– Dec. 1900 No panic 2.78 −6.7 0.001 0.3 (12) Sept. 1902– Aug. 1904 No panic −4.13 −8.7 0.001 0.6 (28) May 1907– June 1908 Oct. 1907 11.45 −46.5 0.001 0.3 (20) Jan. 1910– Jan. 1912 No panic −2.64 −21.7 0.0002 0.1 (10) Jan. 1913– Dec. 1914 Aug. 1914 10.39 −47.1 0.001 0.4 (28)

Source: Gorton (1988).

1873, 1893, and 1907. The next two columns show the percentage change in the currency- deposit ratio and the percentage change in pig iron production, both measured from the panic date to the trough of the recession. The currency- deposit ratio provided a good indication of the degree of intermediation in the economy, and sharp spikes upward typically signaled depositor concerns about the health of the banking system— a “show me the money” moment. Even though these panics involved suspensions of convertibility, still the currency- deposit ratio rose quite signifi cantly during panics. National income accounting was not yet invented, and so economic historians look at pig iron production as a measure of real economic activity. Pig iron was used to make rails for trains among other things. By this measure, it is clear that the recessions associated with panics were very severe. However, while the recessions were severe, the losses per deposit dollar, calculated by the US comptroller of the currency for nationally chartered banks, were all less than a penny except for 1873 (2 cents per dollar) and 1893 (one cent per dollar). Also, the number of banks that failed during the panics (as a percentage of the total number of banks) was very small. Evidently, although the economic downturns were severe, the costs to the banking system— once through the panic— were very small.

How could a systemic bank run occur and nearly shut down the fi nancial system and yet afterward losses on deposits are so small and the number of banks that failed is also small? During the crisis, depositors do not know which banks will end up insolvent or, indeed, whether the banking system is insolvent. Depositors (or short- term debt holders more broadly) observe unexpected information that a recession is looming and that the fi nancial

system is at risk. The threshold for fi nancial risk is a widely observed fi nancial shock that unsettles depositor confi dence. Fearing that their bank might default in the recession, depositors run on their banks— all banks then face the potential of enormous demands for cash. In the National Banking Era, the response in the most severe crises was for banks to (illegally) suspend or severely restrict convertibility— that is, they refused to give out cash in exchange for their deposits. There is a shortage of cash and fi rms cannot meet their payrolls. Taxes cannot be paid. Purchases of goods and services become diffi cult or impossible.

What is to be done? Faced with the crisis, the clearinghouse took the lead in managing information. To convince panicky depositors that the banking system was solvent, the clearinghouse focused attention on itself (essentially the banking system, in the case of the New York Clearing House Association), suppressing bank- specifi c information. During the suspension period, only aggregate information about the clearinghouse was released, in particular the reserve surplus (reserves relative to required reserves). The clearinghouse then produced some information that was made public, namely through special bank examinations (like stress tests for selected banks). And bank bailouts of individual members were part of managing the information environment and hence expectations.

There was another aspect of the information environment that is very important. At the start of the suspension period, the clearinghouse transformed (legally) into a single institution by issuing clearinghouse loan certifi cates and certifi ed checks, which were the joint liabilities of the clearinghouse members. These joint liabilities implied that the clearinghouse effectively combined the member bank resources into one big bank, a kind of temporary central bank. (See Timberlake 1984; Gorton 1985; and Gorton and Mulli neaux 1987.) With the aggregate asset portfolios of the member banks, the clearinghouse could be perceived as safer than any single bank member. The clearinghouse itself was a kind of club that banks could join for a fee if they satisfi ed certain rules. But in a panic, member banks became a single bank until the conditions of panic were gone. When most of the clearinghouse loan certifi cates were retired and suspension of convertibility no longer applied, then bank- specifi c information became public again.

Also, during panics, certifi ed checks, claims on the clearinghouse, were used as a transaction medium. But these checks were not as good as money. This resulted in a new market opening, where these instruments traded publicly at a “currency premium,” for example, to buy $1.00 of currency required $1.05 of certifi ed checks— a 5 percent premium. These prices (the premiums) were a source of information. Beliefs about the solvency of the fi nancial

system cannot be directly measured, but the currency premiums are a good proxy for beliefs, a market price. Prices aggregate and embed information, and a fi nancial crisis is all about information. The currency premium was a measure of systemic bank risk, excess demand for cash because of fears that the clearinghouse might be insolvent.4 It focused attention on systemic risk, rather than individual bank risk. The premium started high and over time it (nonmonotonically) declined. Eventually, convertibility was reinstated. In short, the information environment was managed by the clearinghouse so that systemic risk was refl ected in the currency premium. When that went to zero, resumption of cash payments occurred.

The clearinghouse managed information: Some information was suppressed, and some information was produced and released by the clearinghouse. And fi nally the market for cash opens with an information- revealing price. How does this changing mosaic of information restore confi dence? It is important that bank- specifi c information was suppressed, as well as the release of information about the clearinghouse, now that the members combined into one big bank. And the new market for cash revealed information about the solvency of the big bank— the entire New York Clearing House membership.

We show that there was a specifi c timing of events and sequence of actions that led the fi nancial markets back to normalcy. For normalcy to return, the currency premium had to become zero, refl ecting the belief that the clearinghouse was solvent, with the implied probability of systemic default going from roughly 5– 10 percent to zero. When the currency premium became zero, fears that the banking system was insolvent had faded. Only then does resumption of convertibility occur. The currency premium went to zero because there were observable improvements in the state of the clearinghouse. Before the premium hit zero, the reserve surplus (total clearinghouse reserves in excess of required reserves) looks healthier, partly because of gold infl ows. The special bank examinations turned up no insolvent banks, and this was observable. And fi nally, individual bank data starts being published again, but only after a delay of about a month. Notably, the reserve surplus, which becomes negative at the start of the panic, does not have to be positive prior to resumption but merely display an upward trend. In the aftermath there were few bank failures and no losses to the clearinghouse on loan certifi cates.

During the Panic of 2007– 8, the Federal Reserve System made public the total amount of resources it made available to the banking system, but the identities of the banks that used the emergency lending facilities were not revealed. Preventing the identifi cation of “weak banks” put the onus on the banking system and the question of its solvency. Then the key issue was

whether the Federal Reserve did, in fact, have the needed resources and the wherewithal to shore up the fi nancial system. It was the same during the National Banking Era. When a fi nancial crisis took place, the New York Clearing House played an analogous role for the fi nancial market. In both cases, fi ghting crises was about information— having the information and managing the amount and the form in which it was released.