Deposit Insurance and Moral Hazard: Evidence from Texas Banking in the 1920s
The paper "Deposit Insurance and Moral Hazard: Evidence from Texas Banking in the 1920s" by Linda M. Hooks and
Kenneth J. Robinson provides an empirical analysis of the effects of deposit insurance on bank behavior using detailed
bank-level data from 1919 to 1926. The authors examine whether the introduction of deposit insurance in Texas increased
the likelihood of bank failures and encouraged riskier lending practices.
Key Findings:
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Impact of Deposit Insurance on Bank Failures: The authors used a probit model to estimate the likelihood of
bank failure and found that insured banks in Texas had a significantly higher probability of failure compared to
uninsured banks. For instance, the variable representing whether a bank was insured (INSURED) was positive and
statistically significant, indicating that deposit insurance increased the likelihood of failure by about 10%. This
highlights the moral hazard problem, where banks, protected by insurance, engage in riskier activities.
Increased Risk-Taking Behavior: The analysis shows that state-chartered banks under the deposit insurance
system took on greater asset risks after experiencing declines in capitalization. The authors used measures such as
the loan-to-asset ratio to proxy for asset risk. They found that banks with lower capitalization levels increased
their loan concentration, especially in risky sectors such as agriculture and real estate. For example, the
concentration of agricultural loans to assets (AGLOANS) was positively correlated with declines in bank capital,
with a coefficient of -0.4735 in one of the models.
Comparison with Uninsured Banks: Uninsured national banks, which served as a control group, did not display
the same risk-taking behavior as insured state-chartered banks. The capitalization variable (TOTCAP) was not
statistically significant in predicting loan concentration for uninsured banks, suggesting that the moral hazard
effect was present only in insured banks.
Data Sample: The data used in the study came from balance sheets and examination reports of Texas banks. The
sample included 89 state-chartered banks and 50 national banks. On average, insured state-chartered banks in the
sample had a capital-to-asset ratio of 23%, higher than the 19.7% for all Texas state banks, but they were more
likely to fail. Insured banks also had a loan-to-asset ratio of 65.43%, slightly lower than the average for all state
banks (68.1%), yet they pursued riskier loan portfolios in sectors like agriculture and real estate.
Historical Context: The deposit insurance system in Texas was part of a broader trend among eight states to
implement formal deposit guarantee programs in the early 1900s. Texas’ system, established under the
Meachum-Greer Bill of 1909, was mandatory for state-chartered banks. However, the insurance fund became
insolvent by 1926 due to the strain of increasing bank failures, exacerbated by the moral hazard problem.
Data Summary:
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Loan-to-Asset Ratio:
○ Insured State Banks: 65.43%
○ Uninsured National Banks: 58.6%
Capital-to-Asset Ratio:
○ Insured State Banks (Sample): 23%
○ All Texas State Banks: 19.7%
○ Uninsured National Banks: 18.8%
Asset Size (Average):
○ Insured State Banks: $465,280
○ Uninsured National Banks:
$2,425,072
Conclusion:
The study provides strong evidence that deposit
insurance in Texas led to moral hazard, where banks,
shielded from failure by insurance, increased their
exposure to risky loans, which contributed to the collapse
of the deposit insurance system. By contrasting insured
state-chartered banks with uninsured national banks, the
paper underscores the need for carefully designed deposit
insurance systems, such as risk-based premium
structures, to avoid creating incentives for excessive
risk-taking.
The findings from this historical case provide valuable
lessons for modern financial systems in managing the
trade-off between deposit protection and financial
stability