This story might sound familiar.

An American financial firm, which has been engaging in loosely regulated activities under limited supervision by financial authorities, teeters on the edge of collapse. No one bails out the company, and it closes its doors. Chaos erupts in the financial sector. Other firms are rescued, but not before the country’s economy enters a tailspin.

Most people would recognize these details from the 2008 financial crisis, when the investment bank Lehman Brothers was allowed to fail. But this same story unfolded a century earlier. The Panic of 1907 led to turmoil among unregulated “shadow banks” in New York, and a recession ensued. 

“It’s probably the best historical parallel with the recent financial crisis,” says Carola Frydman, a professor of finance at Kellogg.

Nailing down cause and effect with economic crises is difficult: Does the collapse of the financial sector cause the declines of companies in other industries? Or does the instability start in nonfinancial firms and spread to banks? Frydman and her collaborators, Eric Hilt of Wellesley College and Lily Zhou, who was a Wellesley student at the time, thought that investigating the 1907 panic could help answer these questions.

Why, exactly, did the bank failures drag down companies in other industries?

Due to the 1907 panic’s peculiar circumstances, Frydman could tease apart these factors. She and coauthors found that shocks to banks did appear to trigger upheaval in connected companies outside the financial sector. The panic caused a substantial portion of the decline in investment, and the fallout lasted several years.

“Shocks to financial intermediaries might have very large consequences for the aggregate economy,” she says. And those effects “can persist well beyond the financial markets’ recovery.”

Frydman cautions that this chain of events does not entirely match those leading up to the 2008 crisis, since the financial sector has changed so much. But she says the findings suggest that when unregulated activities rapidly expand, “that could potentially be a very big source of risk.”

Understanding the Financial Panic of 1907

The Panic of 1907 began when a speculator in New York, Otto Heinze, led an attempt to squeeze short sellers of the shares of a mining firm. The speculation failed, and Heinze’s brokerage firm was suspended from the stock exchange.

Ripple effects soon spread to two other men linked to the scandal, financier Charles W. Morse and Heinze’s brother Augustus, who controlled some commercial banks and who had used some of their resources to finance their ventures. Worried depositors rushed to withdraw their funds from the Mercantile National, the bank most prominently associated with Morse. But the New York Clearing House (NYCH), a private organization that would often act as a lender of last resort for its member banks prior to the establishment of the Federal Reserve System in 1913, bailed out Mercantile and stopped the drain on its funds. As a condition for this aid, however, the NYCH required that Morse and Augustus Heinze very publicly resign from their directorships with commercial banks.

The bank run might have ended there had it not been for a connection to a company called Knickerbocker Trust.

“Knickerbocker is the Lehman of this story,” Frydman says.

This firm was a trust company, and it performed many activities similar to those of commercial and investment banks of the time. However, trust companies were much less regulated. For example, they were not required to keep a certain percentage of deposits on hand until 1906, whereas the reserve requirement for national banks was 25 percent. Trust companies, the shadow banks of the time, had expanded substantially in the decade leading to the crisis.

Knickerbocker’s president, Charles T. Barney, was connected to Morse and Augustus Heinze, fueling suspicions that his firm also was in trouble. Their clients panicked and rushed to withdraw their deposits. Because Knickerbocker was not a member, the NYCH would not bail out the company; the financier J.P. Morgan also refused to help, since he could not determine whether the company was insolvent or illiquid in the time available. The run drove the firm to close its doors

From there, turmoil spread to other trust companies. One article in Everybody’s Magazine described the atmosphere as “sheer blind, unreasoning fear.” Morgan ultimately arranged bailouts of some firms, partly with U.S. Treasury funds. Nevertheless, corporate investment plunged by about 25 percent over the next year, and the country entered a major recession.

This historical episode gave Frydman and her collaborators an opportunity to study how a banking collapse affected firms outside the financial sector. In this case, the instability clearly started with the banks and “spread through these almost personal connections,” Frydman says.

A Tangled Web

The researchers first looked for connections between trust companies and Morse, Augustus Heinze, Barney, and two other men linked to the failed mining speculation.

By consulting directories listing the board members of financial institutions, the team identified trust companies where at least one of the involved men served on the board of directors—a direct link—or at least two board members overlapped with those at a directly linked company. Trust companies were also considered to be connected to the scandal if they had deposited money into or received deposits from directly linked firms.

The instability started with the banks and “spread through these almost personal connections.” 


Frydman and her colleagues found that deposits at trust companies unconnected to the scandal declined by 23 percent. But deposits at firms with direct or indirect links fell by 53 percent.

“People were more likely to run and withdraw their deposits if they felt, ‘Hmm, these trust companies are somewhat connected to these men that were crooks,’” she says.

Next, the researchers scoured the 1907 Moody’s Manual of Railroads and Corporation Securities for relationships between trust companies that suffered the greatest losses and firms in other industries, such as transportation and manufacturing. The manual did not reveal which firms were the trust companies’ clients. But the researchers considered a nonfinancial company to be connected to a tainted trust company if at least one member of their boards of directors overlapped.

The team then analyzed the performance of 125 nonfinancial companies, 61 of which were linked to the hardest-hit trusts, immediately following Knickerbocker’s downfall. The researchers estimate that among mid-sized industrial firms, stock returns at a connected company dropped by 60 percent more than those at a similar but unconnected company. Over the next several years, the linked firms also performed worse on several financial indicators, such as profitability and investment rates, than their unlinked peers.

Overall, the financial shock to trust companies drove at least 18 percent of the $700 million investment losses in the American economy in 1908, the team estimates.

Large nonfinancial firms connected to trust companies under severe strain only saw their investment rates decline in 1908 relative to similarly sized firms with no such connections. But the effects on small and medium-sized firms lasted three to five years. Those companies may have needed time to establish new relationships with other banks, or perhaps their clients had fled to competitors.

“If you loose a big chunk of your market, that might be much harder to rebuild” Frydman says.

Dried-Up Lending

But why, exactly, did the bank failures drag down companies in other industries?

The data showed two possibilities. The first was that the struggling trust companies provided fewer financial resources, such as lending, to clients. The second was that nonfinancial companies’ reputations suffered because they were linked to the tainted trust companies.

To figure out which factors were at play, the team studied commercial banks that had included one of the speculators on their boards. The clearing house rescued those banks, so they would have little reason to reduce lending.

“Clearly, they were part of the scandal,” Frydman says. “But they didn’t get any liquidity shock.” So if reputation alone drove company declines, then nonfinancial firms linked to those commercial banks should have fared badly.

The researchers saw no evidence of that. Companies connected to the tainted banks did not perform worse than unlinked firms after the panic. So the study suggests that a decrease in lending was likely responsible.

Misunderstood Risks

Since 1907, the banking industry has undergone major changes. The United States now has a federal lender of last resort, the Federal Reserve System. The financial sector is much more complex, and many new regulations exist.

But Frydman sees parallels between the activities of modern investment banks such as Lehman and the early 20th-century shadow banks. If part of the financial sector is expanding rapidly without much regulation or supervision, the risk of failure is high, “with very negative consequences for the economy,” she says.

One lesson from history, she says, is that “inaction is really a bad thing.”

If Knickerbocker had been rescued, perhaps the financial panic would not have spread to other trust companies. “Who knows what would have happened if Lehman had been bailed out?” she asks.

Frydman acknowledges that bailouts come with their own risks. If financial firms feel secure that they will always be rescued, they have less incentive to act responsibly.

Still, one bank failure can set a larger collapse in motion. “Once a crisis gets going,” she says, “it’s relatively hard to stop.”