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Stealing Deposits: Deposit Insurance, Risk Taking, and the Removal of Market Discipline in Early-20th-Century Banks

Our findings not only corroborate the prior literature on the moral-hazard consequences of deposit insurance but also show how the introduction of deposit insurance created systemic risk. We find conclusive evidence that deposit insurance caused risk to increase in the banking system by removing the market discipline that had been constraining uninsured banks’ decision-making. Depositors applied strict market discipline on uninsured banks when evaluating whether to place their deposits in those banks but seemingly ignored the financial soundness of insured banks. Insured banks thus were able to use the promise of insurance to compete away deposits from uninsured banks. Because they were constrained only by regulatory standards (i.e., a minimum capital-to-deposits ratio; a minimum reserves-to-deposit ratio; and in some cases, a maximum interest rate paid on deposits) that often proved inadequate to prevent insolvency, insured banks raised their loan-to-asset ratios, reduced their cash reserves, and kept their capital ratios close to the regulatory minimum.

Insured banks seemingly were betting on the permanence of agricultural price increases that had occurred during World War I, and depositors seemingly believed in the insurance systems’ ability to protect them. Deposits flowed most strongly into insured banks located in counties where the price rises had the biggest effect. As banks most often used those deposits to fund new loans, the implementation of deposit insurance allowed an asset price bubble to quickly form. When prices reversed in the early 1920s, the insured banking systems collapsed and left depositors with losses.

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