What are the Connections between Deposit Insurance and Bank Failures?

Abstract

The purpose of this paper is to examine the historical evidence on commercial bank failures in the United States in order to assess the validity of the widespread belief that deposit insurance has increased bank failures due to the moral hazard that it represents for bank management.¹ It seems paradoxical that this belief has passed into the conventional wisdom when little more than a decade ago its opposite was generally accepted. In 1980 it was widely believed that the historically low failure rates enjoyed since the Great Depression were due to the introduction of federal deposit insurance in 1934.² By the end of the 1980s deposit insurance was considered the major cause of bank failures. Can it be both? The remainder of the introduction describes the essential elements of potentially fruitful approaches to this question followed by an outline of our approach and a preview of our results.

Federal insurance of bank deposits was the most important structural change in the banking system to result from the 1933 panic, and, indeed in our view, the structural change most conducive to monetory stability since state bank notes were taxed out of existence immediately after the Civil War. —Friedman and Schwartz(1963)

Federal deposit insurance currently subsidizes in a largely hidden way way important categories of deposit-institution risk bearing....[The resulting ] incentive problems create a system of guarantees that over time has grown increasingly costly, unfair, dangerous, and unreliable. —Edward Kane (1987)