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Income Shocks and the Mechanics of Bank Distress: Evidence from the 1920s Commodity Price Bust
How do negative shocks to borrower income affect bank stability? We show theoretically and empirically that income shocks can explain bank distress via an asset- and a liability-side channel. Exploiting an exogenous commodity price bust that hit the U.S. agricultural sector in the early 1920s and novel micro data, we find that realized and expected declines in income caused loan defaults and deposit withdrawals. While the shock‘s effects on both sides of the balance sheet drove bank distress, the loss of stable funding represented the key driver. We document that public liquidity provision reduced bank instability and provide evidence suggesting that real adjustment to the financial fallout of the shock took the form of out-migration and changes in ownership structure.
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