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Working Paper 1992-002A

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"The Slack Banker Dances: Deposit Insurance and Risk-Taking in the Banking Collapse of the 1920s"
by David C. Wheelock, and Subal C. Kumbhaker

This paper studies the effects of deposit insurance on bank behavior using individual bank data from Kansas in the 1920s. Kansas banks were severely stressed by the collapse of agricultural prices in 1920 and resulting increase in farm mortgage defaults. Because membership in the state deposit insurance system was voluntary, it is possible to compare the behavior of insured and non-insured banks facing similar exogenous circumstances. We find that deposit insurance encouraged excessive risk-taking, which helps to explain the comparatively high failure rate of insured banks. The deposit insurance fund ultimately failed
to reimburse many depositors of failed banks. We find, however, no evidence of a decline in the credibility of insurance, and hence in the ability of insured banks to take excessive risks, before the system’s collapse in 1926.

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Category > Banking
Author > David C. Wheelock