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Which Banks Choose Deposit Insurance? Evidence of Adverse Selection and Moral Hazard in a Voluntary Insurance System

The sharp increase in depository institution failures in recent years has drawn attention to the moral hazard created by under-priced deposit insurance. To identify possible reforms, researchers have begun to consider alternative deposit insurance arrangements. This paper contributes to that literature by examining the deposit insurance system of Kansas, which operated from 1909 to 1929. The Kansas system had a number of regulations that were intended to limit risk-taking, and membership was made voluntary to assuage objections that insurance forces conservative banks to protect depositors of high-risk institutions. Using individual bank data, we test explicitly whether adverse selection and moral hazard characterized the Kansas system. We find that risk-prone banks were the most likely to join the system at its inception. And, using a simultaneous equation model, we find that both adverse selection and moral hazard behavior were present throughout the system?s first ten years.

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