Does Increased Shareholder Liability Always Reduce Bank Moral Hazard?
70 Pages Posted: 27 Dec 2017 Last revised: 26 Sep 2019
Date Written: September 15, 2019
Scholars and regulators have long maintained that increased shareholder liability mitigates banks' excessive risk-taking. Prior to the Great Depression, regulators imposed double liability on bank shareholders to constrain moral hazard and protect depositors. Under double liability, shareholders of failing banks lost their initial investment and had to pay up to the par value of the stock in order to compensate depositors. In this paper, we examine whether increased shareholder liability in the double-liability framework was effective at moderating bank risk-taking. We first develop a model that demonstrates two competing effects of increased shareholder liability: a direct effect that constrains bank risk-taking due to increased skin in the game, and an indirect effect that promotes risk-taking due to endogenously weaker monitoring by better-protected depositors. We then test the model's predictions using a novel identification strategy that compares state Federal Reserve member banks and national banks in New York and New Jersey. We find no evidence that double liability reduced risk-taking prior to the Great Depression. However, we do find evidence that deposits in double-liability banks were stickier during the Great Depression, suggesting that shareholders of double-liability banks faced less risk of bank runs. The empirical evidence that shareholder liability did not effectively mitigate bank risk-taking is consistent with the shifting of losses from depositors to shareholders weakening market discipline, and attenuating the effects of increased skin in the game.
Keywords: Double Liability, Moral Hazard, Market Discipline, Bank Runs, Great Depression
JEL Classification: G21, G28, N22
Suggested Citation: Suggested Citation