Does Deposit Insurance Promote Deposit Stability? Evidence from the Postal Savings System during the 1920s

Overview

Research question. Does deposit insurance promote financial depth by arresting the outflow of deposits from the banking system during periods of bank distress? The paper tests and quantifies the deposit-stabilizing effect of state-level deposit insurance schemes operating in the United States during the 1920s.

Setting and identification. Between 1908 and 1929, eight primarily Midwestern states adopted some form of deposit insurance. The paper exploits the discontinuity in deposit insurance coverage at state borders to identify the causal effect of insurance on depositor behavior. The identification strategy compares outcomes in contiguous city pairs straddling deposit-insurance (DI) and non-deposit-insurance (NDI) state borders — a quasi-experimental design that controls for observed and unobserved confounders by using narrow geographic areas where the only relevant policy difference is the presence or absence of deposit insurance.

Proxy for “mattress money.” The paper uses postal savings deposits as a proxy for money withdrawn from the banking system. The U.S. Postal Savings System (established 1911) was backed by the full faith and credit of the federal government, with a maximum individual account limit of $2,500, and was widely viewed as a far safer alternative to commercial bank deposits. The authors validate this proxy by demonstrating, via Johansen cointegration tests, that the nationwide ratio of postal savings balances to total bank deposits is cointegrated (rank 1) with the currency-deposit ratio — a well-established indicator of banking distress.

Data. The empirical analysis covers 1921–1929. The main postal savings dataset is drawn from Annual Reports of the Postmaster General. Bank suspension data are drawn from FDIC manuscript lists compiled in the 1930s by FDIC economist Clark Warburton, providing location, charter type, and suspension/reopening dates. The sample includes 74 city pairs across 14 states (7 DI: North Dakota, South Dakota, Nebraska, Kansas, Oklahoma, Texas, Mississippi; 7 NDI: Minnesota, Iowa, Missouri, Arkansas, Louisiana, Tennessee, Alabama), with an average distance between paired cities of approximately 18 miles.

Main findings — postal savings regressions (Table 4). Using OLS with city-pair and year fixed effects and standard errors clustered at the NDI city level, the paper finds that following a bank suspension within a 10-mile radius, postal savings deposits in NDI cities grew 16 percent more than deposits in the corresponding DI city. The effect is positive and statistically significant at the 20-mile radius but smaller — approximately 9 percent — and is statistically indistinguishable from zero at the 30-mile radius. The localized decay with distance is consistent with a geographically contained flight-to-safety response. Critically, when the same specification is estimated for periods after deposit insurance was discontinued, the effect at all radii is statistically nil, providing a falsification test ruling out omitted unobserved factors as the driver.

Persistence of effects (Table 5). Arellano-Bond GMM dynamic panel regressions confirm that the disintermediation effects are persistent. The lagged dependent variable enters with a negative and statistically significant coefficient (approximately −0.20 for the 10-mile regression), indicating mean reversion, but the bank suspension coefficients remain robust. Implied long-run effects for the 10-mile and 20-mile equations are approximately 0.151 and 0.100, respectively, suggesting sustained rather than transitory deposit diversion away from the banking system in the absence of deposit insurance.

Banking capacity (Table 6). Because the postal savings deposit limit constrained the intake of funds — particularly severely during distress episodes, as documented through narrative evidence from the 1915 Congressional Record — the postal savings regressions underestimate the true effect of deposit insurance. The paper therefore estimates an alternative specification at the county level, comparing deposits at state-chartered banks in paired DI and NDI border counties. The results indicate that deposit insurance is associated with approximately a 56 percent increase in county-level deposits at state-chartered banks (coefficient 0.574, significant at 5 percent, robust to inclusion or exclusion of year fixed effects). By contrast, the analogous coefficient for national banks — which were prohibited by the OCC from participating in state deposit insurance schemes — is positive but statistically insignificant, providing a placebo test consistent with the interpretation that deposit insurance, not unobserved county characteristics, drove the banking capacity difference.

Scope conditions. All effects are estimated for state-chartered bank deposits in predominantly agricultural, Midwestern border counties during 1921–1929, a period characterized by an average annual bank suspension rate of 2.22 percent (versus 0.3 percent during 1911–1920). The paper acknowledges that state deposit insurance schemes of this era generated moral hazard (as established by prior literature), and frames the contribution as quantifying the stability-enhancing component rather than the net welfare effect.

Policy implication. The 56 percent banking capacity differential implies that deposit runoffs in the absence of insurance are substantially higher than the 3–10 percent runoff rates assumed in the Basel III Liquidity Coverage Ratio (LCR) framework, and more consistent with the 25–50 percent runoffs observed in non-systemic institutions in Denmark following an exogenous reduction in deposit insurance limits (Iyer et al., 2016).

Q&A

Q1: Why is the Postal Savings System a valid proxy for “mattress money,” and what evidence supports this? The postal savings system was backed by the full faith and credit of the United States, making it categorically safer than commercial bank deposits, and was explicitly designed to attract savings hidden in mattresses. The authors validate the proxy empirically by showing that the nationwide ratio of postal savings balances to total bank deposits is cointegrated (Johansen test, rank 1) with the currency-deposit ratio — a series that rises during banking distress as depositors convert bank funds to currency. Contemporary narrative accounts from the 1915 Congressional Record further confirm that postal savings offices experienced sharp deposit inflows during local banking distress, with deposit intake frequently constrained by the $2,500 individual account cap.

Q2: What is the identification strategy, and why does it address endogeneity concerns? The strategy exploits the discontinuity in deposit insurance at state borders by comparing relative postal savings deposit growth in contiguous city pairs — one city in a DI state, one in an adjacent NDI state — conditioning on bank suspensions within 10, 20, or 30 miles. The authors argue that deposit insurance legislation was a statewide political decision driven largely by partisan composition (Democrats favored it, Republicans opposed it), making it implausible that interests concentrated at border cities systematically determined which states adopted it. Six of the seven NDI control states introduced deposit insurance legislation but failed to pass it, underscoring that the policy variation was not determined by border-specific characteristics. A falsification test using the same city pairs after deposit insurance was discontinued shows zero effects, ruling out time-invariant unobserved heterogeneity as the driver.

Q3: What are the main quantitative results from the city-pair postal savings regressions? Following a bank suspension within 10 miles, postal savings deposits in NDI cities grew 16 percent more than in DI cities (coefficient 0.162, significant at 5 percent). At the 20-mile radius the differential is approximately 9 percent (coefficient 0.0933, significant at 5 percent). At the 30-mile radius the coefficient is 0.0997 and statistically indistinguishable from zero. These results are estimated with OLS using city-pair and year fixed effects and standard errors clustered at the NDI city level, based on 524 observations for the 10- and 20-mile specifications and 66 observations for the post-discontinuation falsification regressions.

Q4: How does the paper establish that distance matters for the flight-to-safety effect? The monotonic decline in the estimated coefficient from 0.162 (10 miles) to 0.093 (20 miles) to a statistically insignificant 0.100 (30 miles) indicates that the diversion of deposits into postal savings was geographically localized. This pattern is consistent with depositors responding primarily to nearby bank failures rather than to distant ones, and it supports the interpretation that the effect is driven by local banking distress rather than by state-level or regional macroeconomic shocks that would affect all pairs symmetrically.

Q5: Are the disintermediation effects of bank suspensions temporary or persistent? The Arellano-Bond GMM dynamic panel regressions (Table 5) show that the effects are persistent. The lagged dependent variable coefficient is approximately −0.205 (10-mile) and −0.188 to −0.201 (20-mile), indicating partial mean reversion but not full reversal. Year-1, Year-2, and implied long-run dynamic effects are all statistically significant and of similar magnitude (approximately 0.145–0.152 for the 10-mile equation and 0.096–0.100 for the 20-mile equation), indicating that once depositors shift funds to postal savings in response to bank suspensions, a substantial portion of the effect persists in subsequent years. This is consistent with prior literature showing that deposits leave the banking system quickly but return slowly.

Q6: Why are the postal savings coefficient estimates considered a lower bound on the true effect of deposit insurance? Two institutional features constrained the postal savings system from fully capturing flight-to-safety deposits. First, individual accounts were capped at $2,500, and narrative evidence shows that this limit was severely binding during distress — depositors attempted to place far more than the ceiling allowed. Second, the re-depositing rate of postal savings funds back into local banks was not 100 percent: during 1921–1923 only 32–47 percent of postal savings deposits were re-deposited in banks, compared to 72–82 percent in calmer years. Because the postal savings system could not absorb unlimited deposits and did not fully recycle absorbed funds into local banking, its level understates the true flight of deposits from the banking system in NDI states.

Q7: How does the county-level banking capacity test address the censoring problem? The paper estimates log-ratio regressions comparing county-level deposits at state-chartered banks in DI versus NDI border counties, using a “DI Active” indicator that switches on when deposit insurance is in effect in a given state-year and switches off when schemes are discontinued. Because different states discontinued their insurance at different times, there is sufficient within-county variation to identify the DI coefficient even with year fixed effects. The estimated coefficient of 0.574 (without year FE) and 0.557 (with year FE) translates to approximately a 56 percent higher deposit level in state-chartered bank counties with deposit insurance, with virtually identical estimates across specifications.

Q8: What is the placebo test for national banks, and what does it show? National banks were prohibited by the Office of the Comptroller of the Currency from participating in state deposit insurance schemes. If deposit insurance — rather than unobserved county characteristics — is responsible for the 56 percent banking capacity premium, then county deposits at national banks in DI states should show no corresponding premium. The Table 6 results confirm this: the DI Active coefficient for national bank deposits is positive (0.165 to 0.267) but statistically insignificant, providing a falsification result consistent with the causal interpretation for state-chartered banks.

Q9: How does the paper situate deposit insurance’s stabilizing benefits relative to its moral hazard costs? The paper explicitly frames its contribution as quantifying the stability-enhancing component of deposit insurance separately from the moral hazard component. It cites extensive prior literature (Calomiris 1992, 1993; Wheelock 1992, 1993; Wheelock and Wilson 1994) establishing that the 1910s–1920s state schemes generated moral hazard: insured banks reduced capital-to-asset ratios, relaxed lending standards, and increased risk exposure. The paper does not contest those findings but argues that the two effects are analytically separable and that the stabilization benefit had significant quantitative magnitude — a benefit that should be accounted for when assessing the net welfare effects of deposit insurance design.

Q10: What are the implications for the Basel III Liquidity Coverage Ratio framework? The Basel III LCR formula assumes that during distress 3 percent of “stable deposits” and 10 percent of “less stable deposits” run off. The paper’s finding that deposit insurance is associated with a 56 percent increase in banking capacity implies that in the absence of insurance, deposit runoffs are far higher than these Basel assumptions — substantially larger than 10 percent and more consistent with the 25–50 percent runoffs observed for non-systemic banks in Denmark following an insurance limit reduction (Iyer et al. 2016). The authors argue their results suggest that empirical grounding for the LCR runoff assumptions remains insufficient, consistent with critiques by Allen (2014) and Diamond and Kashyap (2016).

Key Concepts

Postal Savings System (as “mattress money” proxy). The U.S. Postal Savings System (1911–) accepted deposits up to $2,500 per individual, backed by the full faith and credit of the United States. In this paper, postal savings deposits are used as a quantitative proxy for money withdrawn from the banking system during distress — “money under the mattress” — validated by cointegration with the currency-deposit ratio.

Policy discontinuity / border-pair design. The identification strategy exploits the fact that deposit insurance was adopted at the state level, creating a sharp policy discontinuity at state borders. Contiguous city pairs straddling DI and NDI state borders are treated as quasi-experimental units, with the within-pair difference in postal savings deposit growth serving as the outcome, controlling for time-invariant city-level heterogeneity and common time effects.

Relative Postal Savings Deposit Growth (RPS). The dependent variable defined as the log-ratio of postal savings deposits in the NDI city to postal savings deposits in the DI city within a pair, and then first-differenced over time. This construction controls for city-pair-level time-invariant characteristics and isolates the differential response to bank suspensions.

Bank suspension. In this paper’s context, a bank suspension is any closure of a bank (state-chartered or national) at a specific geographic location, as recorded in FDIC manuscript lists compiled by Clark Warburton during the 1930s. The variable used in regressions is the change in the number of suspensions within R miles (R = 10, 20, 30) of the paired postal savings offices.

Financial depth / local banking capacity. The paper uses county-level deposits at state-chartered banks as a measure of local banking market size. Deposit insurance is hypothesized to increase financial depth by preventing the diversion of funds out of the banking system during distress, and the 56 percent estimated premium is the paper’s primary measure of the insurance’s capacity-enhancing effect.

DI Active indicator. A time-varying binary variable equal to 1 when deposit insurance was legally in effect in a given state at a given time, and 0 otherwise (including after repeal). Because different states repealed their schemes at different times (Oklahoma 1923, Texas 1927, South Dakota 1927, North Dakota 1929, Kansas 1929, Nebraska 1930, Mississippi 1930), this variable provides within-county variation that identifies the banking capacity coefficient after controlling for county and year fixed effects.

Moral hazard vs. stability-enhancing components. The paper distinguishes analytically between the moral hazard effect of deposit insurance (insured banks undertake riskier projects, reduce capital buffers, relax lending standards) and the stability-enhancing effect (depositors retain funds in the banking system, preventing runs). The paper’s contribution is to quantify the latter component in isolation, using a setting where the two effects can be separated by focusing on depositor — rather than banker — behavior.