Bank Capital and Portfolio Management: The 1930s "Capital Crunch" and the Scramble to Shed Risk

Abstract

We model the trade“off between low“asset risk and low leverage to satisfy preferences for low“risk deposits and apply it to interwar New York City banks. During the 1920s, profitable lending and low costs of raising capital produced increased bank asset risk and increased capital, with no deposit risk change. Differences in the costs of raising equity explain differences in asset risk and capital ratios. In the 1930s, rising deposit default risk led to deposit withdrawals. In response, banks increased riskless assets and cut dividends. Banks with high default risk or high costs of raising equity contracted dividends the most.

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