New York's Safety Fund System

Abstract

Abstract Economists and regulatory agencies justify deposit insurance because they consider banks unique among capitalist firms. Because banks hold highly idiosyncratic portfolios that are hard for outside monitors to value correctly, macroeconomic shocks that threaten the viability of individual banks can threaten the entire system. Although deposit insurance diminishes the threat of bank runs and, thereby, creates a social benefit, deposit insurance also generates potentially large costs, which provides a justification for regulatory oversight and regulation. Like most bank insurance schemes, the Safety Fund was prone to moral hazard, or excessive risk taking by member banks and adverse selection, wherein better banks left the system, leaving only high‐risk banks as members. The system collapsed after only a small number of failures because of poor oversight, moral hazard, adverse selection, regulatory forbearance, and an under‐funded insurance.