Effects of Deposit Insurance Reform on Moral Hazard in US Banking

In cross sections of US banks before the deposit‐insurance system was reformed in the early 1990s, bank risk‐taking was positively associated with bank size and negatively associated with the value of bank charters and bank capital. These empirical associations have an easy theoretical interpretation. Bank size is positively related, while charter value and capital are negatively related, to the moral hazard associated with flat insurance premiums and other aspects of a laxly administered system. Hence the observed associations of risk‐taking with size, charter value, and capital reflected the expected positive relation between moral hazard and risk‐taking. We test the hypothesis that the three associations became weaker after reform. In the case of unsystematic risk, we find no evidence of significant changes for any of the three. In the case of systematic risk, we find that risk‐taking associated with lower charter values and larger size is indeed significantly weaker after reform. Risk‐taking associated with capital ratios is also weaker after reform, though not significantly so. Since systematic risk is undoubtedly the more appropriate measure, reform seems to have reduced moral hazard.