Deposit insurance and moral hazard: Capital, risk, malfeasance, and mismanagement

Hooks and Robinson (2002) argue that deposit insurance in Texas during the 1920s induced banks to invest in riskier assets. Their regressions indicate that this manifestation of moral hazard may explain some of what happened, but not all. Some other mechanism, hitherto overlooked, must also have been at work. A more complete interpretation of what happened recognizes that deposit insurance induced moral hazard of many types. Depositors grew lax in monitoring the safety and soundness of banks. Bankers took advantage of the lack of supervision and advanced their own interests - via malfeasance or mismanagement - at depositors' expense. Bankers reduced reserve holdings and operated with lower levels of capital. All of these manifestations of moral hazard are consistent with the Hooks' and Robinson's regressions. Data drawn from the archives of the Board of Governors highlights the role of malfeasance and mismanagement. In sum, many manifestations of moral hazard afflicted banks in Texas during the 1920s.