Hot money inflows and bank risk-taking: Germany from the 1920s to the Great Depression

Abstract

This paper explores the origins of German banks’ risk-taking in the years preceding the 1931 crisis. The 1920s were marked by a large and prolonged increase in capital flows into Germany, chiefly from the United States and the United Kingdom. This coincided, at the individual bank level, with a rise in leverage and a fall in liquidity. We examine possible connections between the two phenomena. Our analysis is based on a combination of historiographical work and statistical modelling based on a newly hand-collected bimonthly dataset on German reporting banks from 1925 to 1935. Bank by bank we examine the effects of foreign inflows on decisions related to leverage, lending, and liquidity. The Dawes Plan of 1924 and the relative absence of a too-big-to-fail (TBTF) environment allow us to mitigate endogeneity concerns. We suggest that while capital inflows did not seem to impact banks’ liquidity decisions, their impact on leverage was non-negligeable.