Credit Intermediation Lessons from the Canadian Great Depression

This study empirically tests the credit intermediation hypothesis in Canada at the time of the Great Depression. Regulatory policy at that time disallowed bank failures, such that an implicit deposit guarantee and coincident moral hazard risk existed. Based on vector autoregression analyses in the period 1926-1939, we find that the rapid expansion of bank credit prior to 1929 to finance the growth of durable goods investment was a major factor in explaining Canadian output increases. After the crash of 1929, despite government forebearance to keep insolvent banks open, negative credit shocks had a strong dampening effect on output from 1930 to 1932 and again from 1936 to 1938. We conclude that bank bailouts of insolvent institutions do not prevent credit intermediation effects on the economy.Policy implications to recent financial and economic crises are discussed.