Updates from CHICAGO BOOTH


What a 1920s farm bust reveals about financial crises
By Roben Farzad – To understand this spiral, two researchers turned to data about another systemic financial meltdown—this one involving US farms in the trying 1920s.

Professor Raghuram G. Rajan, now India’s top central banker, and Rodney Ramcharan of the US Federal Reserve Board, studied bank failures during the collapse in American agriculture just ahead of the Great Depression, when plunging crop prices combined with excessive borrowing ravaged the countryside and its banks. (Think Jimmy Stewart in It’s a Wonderful Life, only in farmer’s overalls.) During that agrarian panic, banking regulators liquidated the assets of failed banks as quickly as possible.

At the time, local banking markets were segmented due to heavy interstate regulations and the steep transaction costs imposed by distance. Out-of-state banks were not allowed to extend loans to farmers in nearby states. Even if a farmer wanted to deal with a bank several counties over, it was difficult, as few farmers had cars, or phones.

Rajan and Ramcharan characterize this as “an almost ideal laboratory to study” their questions: Can the loss of financing capacity cause assets to sell at a discount relative to fundamental value? Can it also render asset markets more illiquid? And can these forces lead to contagion, propagating shocks through time?

When bank failures reduce local financing capacity, that reduces the recovery rates on failed assets of nearby banks, depresses local land prices, renders land markets illiquid, and accelerates subsequent financial-sector distress among nearby banks. Reduced capacity also leads to lower transaction volume.

Otherwise perfectly good assets—be those fertile, unexploited acres in 1925; secured, prime real-estate bonds in late 2008; or blue-chip, high-quality shares in 2009—will trade at a discount relative to fundamental value when they are sold by distressed owners. No matter how hale and performing an asset may intrinsically be, its real-time value is inextricably linked to the availability of financing. When banks stop extending credit, asset prices will almost reflexively fall. more> http://tinyurl.com/ndkqva7

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