Deposit Insurance, Uninsured Depositors, and Liquidity Risk During Panics

The lack of universal deposit insurance coverage can create liquidity risk during financial crises when uninsured depositors move funds to more secure institutions. However, the broad coverage of modern systems makes this dynamic hard to test. We therefore study the role that the U.S. Postal Savings System played in the Great Depression. The system offered households a federally insured deposit account at post offices throughout the nation, and provides a near-ideal environment to identify this type of liquidity risk. Using either OLS or IV regressions, we find that banks that operated near a post office that accepted deposits were more likely to close between 1929 and 1935. The postal effect is strongest for banks with low liquidity. Alternatively, the effect is weak after the establishment of the FDIC and for those banks with high insolvency risk. The mechanism thus was through depositor withdrawals rather than general risk factors or omitted variables.