Depression-Era Bank Failures: The Great Contagion or the Great Shakeout?

D eposit insurance was created, at least in part, to prevent unfounded bank failures caused by contagion. The legislation that created the Federal Deposit Insurance Corporation (FDIC) was driven by the widespread bank failures of the Great Depression. In the years immediately before the 1934, when the FDIC began insuring bank deposits, over onethird of all extant banks failed. Many observers argue that these failures occurred because the banking industry is inherently fragile since it is subject to contagion-induced runs. Fragility arises because banks gather a large portion of their funding through the issuance of liabilities that are redeemable on demand at par, while investing in illiquid assets. Specifically, loans, which on average account for 56 percent of bank assets, tend to be made based on information that is costly to convey to outsiders. As a result, if a significant segment of bank customers run, that is, quickly require the repayment of their deposits, the bank is unlikely to be able to sell its assets except at a steep discount. Bank failure can result. But do Depression-era bank failures imply the need for governmentprovided deposit insurance, or is there another explanation of the failures other than contagion and inherent fragility? Some observers question the view that banks are inherently fragile. They argue instead that the banking industry developed various market-based means of addressing runs such that the danger of failure was reduced. They also argue that the banks that failed