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Bank capital and portfolio management: the 1930s capital crunch and scramble to shed risk

  • Charles W. Calomiris
  • Berry Wilson

Recent models of banking under asymmetric information argue that depositors penalize banks that offer high-risk deposits. Focusing on New York City banks in the 1920's and 1930's, this study examines how banks manage risk during normal times and in response to severe shocks. We develop and apply a simple framework that identifies the tradeoffs among alternative means of satisfying depositors' preferences for low-risk deposits (i.e. low asset risk versus high capital). During the 1920's profitable lending opportunities and low costs of raising capital prompted banks to increase their asset risk, while increasing capital to maintain low default risks on deposits. Cross-sectional differences in the cost of raising equity explain differences in banks' choices of asset risk and capital ratios. In the wake of the loan losses produced by the Depression, high default risk was penalized with deposit withdrawals. To reduce deposit risk, banks increased their riskless assets and cut dividends, but avoided costly equity issues. Banks with high default risk or with high costs of raising equity contracted dividends the most during the 1930's.

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Paper provided by Federal Reserve Bank of Chicago in its series Proceedings with number 521.

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Length: 515-530
Date of creation: 1996
Date of revision:
Publication status: Published in Conference on Bank Structure and Competition (1996 : 32rd)
Handle: RePEc:fip:fedhpr:521
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