Real deposit insurance limits, the moral hazard problem, and bank failure.

This dissertation investigates an explanation for the high failure rate among depository institutions during 1980s and early 1990s. The moral hazard hypothesis contends that, in the presence of deposit insurance, banks have an incentive to acquire riskier assets than they should because insured depositors, secure in the knowledge that their funds are safe in any event, will not penalize the institution by withdrawing their funds or requiring that a risk premium be added to the rates paid on their deposits. Thus, the moral hazard hypothesis relies on the behavior of two groups of agents, depositors and banks, and the linkage between them. This linkage can be shown by the following schematic: Deposit Insurance {dollar}\o{dollar} Risk Sensitivity of Depositors {dollar}\o{dollar} Risk Taking by Banks {dollar}\o{dollar} Bank Failure. This dissertation focuses on the theoretical derivation and the empirical test of the first two arrows in the above chain of causation.{dollar}\\sp1{dollar} I employ forty-four quarterly cross-sectional data sets covering 60 to 95 percent of all insured commercial banks in the U.S. over the period 1984-1994. The results suggest that as real deposit insurance decreased, depositors\u27 sensitivity to bank risk increased. However, banks did not react to depositors\u27 increased risk sensitivity by lowering the level of their controllable risk, as predicted by the moral hazard hypothesis. ftn {dollar}\\sp1{dollar} The third arrow holds by definition