Caught in the Headlights: Revising the Road Kill Hypothesis of Antebellum Illinois Bank Failures

Winner of the James Soltow Award for Best Paper in Essays 2017

Abstract

Illinois had a dismal free banking experience, with over 80% of its free banks failing by the start of the Civil War. Researchers agree that a dramatic change in bond prices was the catalyst, and some have shown that the riskiest banks, ex ante, were the most likely to fail. This study examines how Illinois free banks adjusted their portfolios in the face of increased political and financial risks prior to Abraham Lincoln’s election as president. Lincoln’s nomination in May 1860 and the Democratic Party schism in June 1860 raised the likelihood of secession and the potential for a significant decline in Southern bond prices. Given this heightened risk, did free bankers reduce their exposure to such a decline? In general, it appears that the free bankers took risks commensurate with expected returns and the uncertain political climate, purchased the most readily available bonds, and had sufficient backing to withstand a moderate decline in Southern bond prices. The dramatic price decline soon after the election appears to have caught many banks by surprise, like a deer caught in the headlights.