Liquidity Risk During the Great Depression

This paper applies Tian's liquidity risk model to analysis the liquidity shocks to the banking industry during the Great Depression. The weekly change of banks' balance sheet shows banks' liquidity preference was changed significantly during 1920s. Call-loans, functioned as today's shadow banking system, created liquidity among banks and provided external resources forbanks to absorb the deposit shocks. It quickly replaced other liquid assets, such as government bonds and cash, as the safety bu er. Such change improved individual banks' efficiency and provided sufficient credit to support economy boom. However, individual banks did not see market limit. When all banks increased the weight of long term investments, the banking industryas whole held too less liquid assets to absorb the systematic shocks, and the call-loan market was overloaded after 1928. The banking industry as whole lost its safety cushion. The stock market crash in 1929 caused the bank panic in two ways: first, the wealth e ffect created extra deposit shocks to banks; more important, the disappear of the call-loan market ruined banks' abilityto absorb liquidity risk. Banks were forced to re-sale their illiquid assetssimultaneously, which led to bank panic