Kansas banking in the 1930s: the deposit insurance choice and implications for public policy

The recent financial crisis reopened debate about how much public assistance to give to distressed financial institutions. Some argue that even traditional assistance in the form of federal deposit insurance can create moral hazard problems, leading banks to take on greater risk once they are insured. ; Authors Spong and Regehr take a look at a unique situation in Kansas among state-chartered banks, in the wake of the 1930s banking crisis, that affords a rare opportunity to compare insured banks with uninsured ones. After the introduction of federal deposit insurance in 1934, a significant number of relatively stronger banks in Kansas chose not to adopt the insurance. The weaker ones that did take on insurance tended to continue maintaining their lower capital-to-asset ratios, suggesting the insurance enabled them to continue competing for depositors despite their riskier capital structures. ; The authors note that even if federal deposit insurance creates adverse incentives and may pose systemic risks, it is also a critical and seemingly permanent part of the U.S. safety net. They conclude with a review of the pros and cons of various approaches to addressing the problem.