Reducing Moral Hazard at the Expense of Market Discipline: The Effectiveness of Double Liability before and during the Great Depression
61 Pages Posted: 27 Dec 2017 Last revised: 18 Oct 2018
Date Written: August 28, 2018
Scholars and regulators have long maintained that extended shareholder liability reduces bank risk-taking. A novel identification strategy is used on a unique dataset to re-examine the effect of double liability on bank risk-taking from 1926 to 1932. During this period, double liability did not reduce bank risk-taking. Depositors lacked sufficient incentives to withdraw deposits and thus failed to discipline banks for excessive risk-taking. The effect of double liability on bank risk-taking remains ambiguous as it failed to resolve agency conflicts between stakeholders. The depositor protection feature of double liability weakened market discipline and reduced shareholders’ incentives to limit bank risk.
Keywords: Double Liability, Moral Hazard, Market Discipline, Bank Runs, Great Depression
JEL Classification: G21, G28, N22
Suggested Citation: Suggested Citation