The Panic of 1907

Why this matters

The Panic of 1907 was the first worldwide financial crisis of the twentieth century, and it turned a recession into a contraction surpassed in severity only by the Great Depression. Its effects are still felt, because it spurred the reform movement that created the Federal Reserve.¹ It's also the clearest early example of a pattern that keeps returning: a run on financial institutions that sit outside the system meant to protect it.

The weak link: trust companies

New York's trust companies were state-chartered institutions that competed with banks for deposits. Because they handled few checks, they kept only around 5% of their deposits in cash, against 25% for national banks. But their deposits could be withdrawn in cash on demand, so they were just as exposed to runs. They were also large lenders to the stock market, making short loans without collateral to brokers on the New York Stock Exchange.¹

Crucially, most trust companies weren't members of the New York Clearing House, the bankers' association that could support its members in a crisis.¹

	Trust company	National bank
Deposits	100	100
Cash on hand	5 (5%)	25 (25%)
Depositors withdraw 10%	10	10
Cash left after paying them	Short by 5	15

The trust company has to call in loans or sell assets in a hurry, at whatever price it can get. Even if its loans were good, it can't turn them into cash fast enough, and the news that it's struggling brings more depositors to the door.

How it unfolded

Federal Reserve History.¹ Limiting withdrawals created a premium on cash and drew in gold from abroad, which appears to have helped the New York market recover.¹ Knickerbocker reopened in March 1908 after raising $2.4 million in new capital.¹

The cost

The panic did real damage. Industrial output fell 17% in 1908 and real GNP fell 12%; only the Great Depression was more severe. Unlike the Depression, though, the economy recovered quickly, in little over a year.¹

What changed: the Federal Reserve

The United States was the only one of the world's major financial powers without a central bank, and in 1907 it had to turn to Wall Street.² Recognizing that the country couldn't keep relying on wealthy individuals to stop a crisis, Congress passed the Aldrich-Vreeland Act on May 30, 1908, which provided emergency currency and created the National Monetary Commission to recommend reforms.² Years of debate followed over how much control bankers and the government should have. President Wilson signed the Federal Reserve Act on December 23, 1913, creating a system of between eight and twelve regional Reserve Banks under a Federal Reserve Board.²

The emergency loan certificates of 1907 were a forerunner of the Fed's discount window, its standing offer to lend to banks, described in The Federal Reserve's Toolkit.¹

The echo in 2008

The Federal Reserve's historians point out how closely 1907 resembled the crisis of 2007 to 2009. Both began among institutions outside the core of the system: trust companies in 1907, and in 2008 investment banks and the "shadow banks," such as hedge funds and money market funds, that lent to them overnight. Both spread from there to the banks at the center of the payments system. The suspension of Knickerbocker Trust and the failure of Lehman Brothers in September 2008 each marked the start of the most severe phase of its crisis.¹ The 2008 Financial Crisis picks up that story.

Key takeaways

• The Panic of 1907 began with a failed stock corner and spread through runs on New York's trust companies.
• Trust companies held about 5% of deposits in cash, against 25% at national banks, and most were outside the Clearing House safety net.
• Knickerbocker Trust closed after nearly $8 million was withdrawn, and overnight stock-loan rates hit 100%.
• J.P. Morgan and the Clearing House banks stopped the panic, but industrial output fell 17% in 1908.
• The crisis led to the National Monetary Commission in 1908 and the Federal Reserve Act of 1913.
• Its pattern, runs on institutions outside the safety net, returned with the shadow banks of 2008.

Check your understanding

A trust company holds $8 million in cash against $160 million of deposits. Depositors want $12 million back in one day. What happens?

1. Nothing much, since $12 million is under 10% of deposits.
2. It's $4 million short and must sell assets or borrow fast.
3. It's insolvent, since its cash is below its deposits.

What was the most lasting result of the Panic of 1907 in the United States?

1. Trust companies were banned from taking deposits.
2. The stock exchange closed for the rest of the year.
3. The reform push that created the Federal Reserve.

What's next

The Federal Reserve faced its first great test two decades later. The 1929 Crash and the Great Depression looks at what happened, and what the Fed got wrong.