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May/June 1994, 
Vol. 76, No. 3
Posted 1994-05-01

Can Deposit Insurance Increase the Risk of Bank Failure? Some Historical Evidence

by David C. Wheelock and Paul Wilson

Many economists have argued that unless premiums are risk-based, deposit insurance will encourage banks to take greater risks than they otherwise would, thereby increasing the likelihood of failure. Because virtually all banks today are insured, isolating the effects of deposit insurance from other regulatory and economic conditions that affect bank performance is problematic. David C. Wheelock and Paul W. Wilson study the impact of deposit insurance by drawing on historical evidence from a voluntary insurance system that operated in Kansas between 1909 and 1929. Because insurance was optional in this system, comparison of insured and uninsured banks facing otherwise similar regulations and economic conditions is possible. The authors find that insured banks held less capital and reserves than uninsured banks, and that banks with low capital and reserves, or a heavy reliance on borrowed funds, were more likely to fail. In short, risky banks were more likely to fail, and members of the state deposit insurance system tended to be riskier than nonmembers.